How the 401(k)-IRA Rollover Thought Process Works
Every decision has a consequence. From RMDs and taxes to passing on an inheritance, go step by step to make an informed choice.
Approaching 70 in less than a year, my client Cathy — trim, vibrant, silver hair up in a bun — is still enjoying her work and has no plans to retire.
But with that milestone age of 70½ right around the corner — the age when required minimum distributions kick in — she had questions.
Cathy’s family is important to her, and her mind was focused on what to do about her 401(k). She learned by calling her plan’s custodian that there are limitations on how her grandchildren can inherit some of that money. The plan isn’t as flexible as she would like.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The plan custodian suggested she might want to move some of her 401(k) funds to an IRA, but Cathy wasn’t sure what that would mean when it comes to taxes for her and the ones she loves. You see, with everything there is a trade-off, a pro, a con, maybe even a string attached. Cathy wanted to know what she was in for.
Advantages of an IRA rollover
On the “pro” side, she would have more choices. She could invest in almost any financial instrument with her IRA funds, including something that might better meet the objectives she had in mind when thinking of her grandchildren. Her 401(k) plan’s options are limited.
She also would be able to create a stretch IRA to benefit the grandchildren. A stretch allows each beneficiary to take distributions based on his or her individual age and life expectancy according to the IRS table.
Cathy liked the idea of providing steady income to help with school expenses, a home purchase and whatever else might come up as her grandchildren got older. She also liked that the IRA would always have her name on it. She truly felt that would be a legacy.
Still, she wanted to know what the trade-offs would be.
Advantages of sticking with a 401(k)
While Cathy works, her 401(k) has some benefits. She can continue to contribute pretax dollars without an age restriction. That part wouldn’t change by rolling some of the account over to an IRA. She would still be able to make those contributions.
More important, as long as she keeps working for her current employer, Cathy is also exempt from taking a required minimum distribution (RMD) on that particular 401(k) when she turns 70½. If she rolled any of the 401(k) into an IRA, that IRA would become subject to the RMD. At 70½, she’d have to take out money, whether she wanted it or needed it. And she’d have to pay taxes on it.
This is a vital consideration — the string attached, so to speak. Cathy feels her work helps her stay healthy, so she plans to keep at it for years to come. Her husband already has Social Security and a pension, and Cathy will start Social Security at age 70. The RMDs would only add to their tax burden, and Cathy wanted to know by how much. She had several questions:
- What would that RMD cost in overall taxes each year?
- Would the extra income raise the percentage of Social Security income that could be taxed?
- Or, if the RMD was small, would it have any impact at all?
RMD possibilities
Cathy also had to decide what she should do with the RMD funds she took from the IRA.
She knew she wanted to earmark the money for her grandchildren, but she would have to determine how to best position the now-taxed dollars to maximize their benefit. She could create a stock portfolio and, as long as she didn’t sell anything, she wouldn’t pay taxes on it. She would have to pay taxes on any dividends earned, but then she could reinvest the money she made. Cathy will want to consider how capital gains might affect her investments before making any final decisions. On death, the stock would receive a step up in basis, and therefore would not be taxed to her grandchildren.
Her other option was life insurance. She could purchase a policy into which she would put her RMDs. This would also distribute money tax free to her grandchildren.
Decision time
Ultimately, after going over all the alternatives and their implications, Cathy chose to roll a portion of her 401(k) into an IRA and name her grandchildren as beneficiaries to create the “stretch” for them. She decided to use the RMDs for life insurance to further her legacy goals.
So much in our retirement planning is about more than money. Often our choices reflect our values in life. Cathy decided to face the possibility of additional taxes so she could provide financial security for her grandchildren.
What are your values? What would you have done?
Kim Franke-Folstad contributed to this article.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Nancy Fleming, CFP®, is the president of Fleming Financial Services, based in Gilbert, Arizona. She is an Investment Adviser Representative and licensed insurance professional.
-
Stock Market Today: The Dow Leads an Up Day for Stocks
Boeing, American Express and Nike were the best Dow stocks to close out the week.
By Karee Venema Published
-
Black Friday Deals: Are They Still Worth It in 2024?
Is Black Friday still the best day for deals? We share top tips for smart holiday shopping.
By Jacob Wolinsky Published
-
Six Missteps to Avoid as You Transition to Retirement
Don't lose sight of your finances when you finally reach retirement. These six classic missteps can chip away at the nest egg you’ve worked so hard to build.
By Bill Leavitt Published
-
Why Does One Claim Jack Up My Insurance After Years of No Claims?
Even loyal customers can be hit with an insurance premium hike after a claim, despite going many years without any claims. There's a reason for that.
By Karl Susman, CPCU, LUTCF, CIC, CSFP, CFS, CPIA, AAI-M, PLCS Published
-
To Future-Proof Retirement Security, We Need Better Strategies
With retirees living longer and the inequalities that affect women and people of color, the retirement system needs some optimization. Here’s what would help.
By Romi Savova Published
-
Here's Why We All Win When Charitable Dollars Go to Women
Giving to charities for women and girls not only has a lasting impact on their lives — it also benefits society as a whole. Here’s how to start investing.
By Elizabeth Droggitis Published
-
For a More Secure Retirement, Build in Some 'Safe Money'
To solidify your retirement plan, write it down, reduce your market risk and allocate more safe money into your plan for income.
By Kevin Wade Published
-
Five Steps to a Mindfully Fearless Career
If, like many women, you're struggling with imposter syndrome, try developing an athlete's winning mindset. It's as simple as facing one small fear every day.
By Lisa Cregan Published
-
Six Ways to Optimize Your Charitable Giving Before Year-End
As 2024 winds down, right now is the time to look at how you plan to handle your charitable giving. The sooner you start, the more tax-efficient you can be.
By Julia Chu Published
-
How Preferred Stocks Can Boost Your Retirement Portfolio
Higher yields, priority on dividend payments and the potential for capital appreciation are just three reasons to consider investing in preferred stocks.
By Michael Joseph, CFA Published