So, it’s time to retire and you’re trying to figure out what to do with your 401(k).
Most folks will end up rolling their 401(k) funds into an IRA. Done properly, the transfer of funds from a 401(k) to an IRA is a nontaxable event. You only pay taxes when you begin withdrawing funds from the IRA. But there could be a couple of complicating factors.
First, do you have any after-tax contributions in the account? And second, if you work for a publicly traded company, do you have any company stock?
If you make contributions to a 401(k) or similar type plan, odds are you are making pre-tax contributions, contributions that reduce your taxable income currently. However, some plans allow for after-tax contributions and you may have a mix of pre-tax and after-tax money in your account. When retirement rolls around, you would normally roll your 401(k) pre-tax money to a traditional IRA account. But if your account contains some after-tax funds, these need to be handled differently. After-tax funds can be distributed out directly to you with no tax implications since you have already paid tax on them. But another alternative is to roll the funds to a Roth IRA.
As an example, assume you have $100,000 in a 401(k), with $20,000 in after-tax funds and the rest pre-tax. Put the $80,000 pre-tax into a traditional IRA rollover and the $20,000 after-tax into a Roth IRA. You can access the $20,000 whenever you want with no taxes and no penalties. You could also deposit the $20,000 into a regular non-retirement account.
But here’s why the Roth option may be best: Suppose you don’t need the funds and you let them accumulate over your golden years. Over time, the $20,000 grows to $35,000. Inside a Roth IRA, you now have $15,000 in gains that you will not be taxed on. By contrast, that $20,000 growing to $35,000 over the same period in a non-retirement account would have created taxable income, and associated tax liabilities, along the way. I should also mention that Roth 401(k) funds can be rolled directly into a Roth IRA as well.
The second issue is company stock held in a retirement account. Assume you are an Albemarle employee with $50,000 worth of Albemarle stock in the 401(k). You purchased the stock for $10,000 so this is your cost basis. The $40,000 gain is referred to as net unrealized appreciation, or NUA. You have two options here: First, you could roll the Albemarle stock to a traditional IRA. In this case, you pay no taxes until you withdraw the funds. But then you get taxed on any withdrawals at ordinary income tax rates. The second option is to roll the Albemarle stock to a non-retirement account. If you do, you will have to pay taxes on the $10,000 cost basis in the current year, again at ordinary income tax rates. But you won’t have to pay tax on the $40,000 in NUA until you sell the stock. And then, it gets taxed at long-term capital gains rates, which may be half or less of ordinary rates. Furthermore, if the stock eventually rises to $75,000, that subsequent appreciation is taxed at cap gains rates as well.
By contrast, assume you bought Albemarle at $10,000, but now it is only worth $12,000. In this case you only have $2,000 worth of NUA that would be subject to cap gains rates. It’s probably not worth paying the tax on the $10,000 today just to get cap gains treatments on the $2,000. You’re probably better off to roll the entire amount into a traditional IRA with your other investments.
Just a couple of things to watch out for when doing a rollover. You worked hard to accumulate that nest egg. So, watch out for these areas to avoid paying excess taxes.
Dr. David Ashby is a Certified Financial Planner and the retired Peoples Bank Professor of Finance at Southern Arkansas University. He holds degrees in accounting and business administration and a doctorate in finance from Louisiana Tech.