401k Direct Rollover
A 401k direct rollover occurs when you transfer funds from an existing 401k retirement account directly into another 401k account or individual retirement account (IRA). The direct rollover is effected by account trustees which means that, unlike a 401k indirect rollover, you never actually come into possession of the funds. The primary benefit of a direct rollover is that you avoid the paperwork, taxes, and penalties associated with an indirect rollover.
In addition to rolling over your retirement savings into an IRA, you also have the option of doing a 401k direct rollover into your new employer’s 401k plan. This is generally not advised, however, because your investment options are more limited in 401k plans and, should you leave your current employer, you’d just have to rollover your 401k again.
One thing to note for those of you who have large holdings of your past employer’s stock in their 401k is the potential that you may end up paying more in taxes should you rollover your 401k vs. taking the distribution in a lump sum due to the differences in how the net unrealized appreciation (NUA) of the stock is calculated. Without getting into great depth of how tax on 401k distributions is calculated, the basic implications are as follows.
Company stock in a 401k plan is often added to an employee’s account with a cost basis (the value on which taxes are calculated) of much less than market value. When taxes are paid upon distribution of the 401k, they’re calculated on the cost basis and not on the current market value of the stock. Thus, assuming the stock has appreciated, the taxes paid when the gains are realized (the stock is sold) are much less than what would have been paid had taxes been assessed based upon current market value.
But, when stock is rolled over into an IRA, the NUA is calculated differently. The difference between the current market value and the cost basis now becomes taxable and this change could result in a significant amount of additional tax when the stock is eventually sold.
Here’s a quick example assuming the company stock is held for the same time period and grows in value to $100,000 before it’s sold. In the first case, it’s moved into a taxable account and, in the second case, it’s rolled over into an IRA:
Moved into a Taxable Account
$10,000 cost basis
$30,000 market value
Taxes paid (at current income tax level): 31% * $10,000 or $3,100
Distribution penalty: 10% * $10,000 or $1,000
Grows to $100,000
Taxable amount is $100,000 – $10,000 or $90,000
Taxes paid (at capital gains tax rate): 20% * $90,000 or $18,000
Total taxes paid: $3,100 + $1,000 + $18,000 = $22,000
Company Stock Rolled Over
$10,000 cost basis
$30,000 market value
Taxes paid: $0
Grows to $100,000
Taxable amount is $100,000 – $10,000 or $90,000
Taxes paid (at current income tax level): 31% * $90,000 or $27,900
Total taxes paid: $0 + $27,900 = $27,900
Thus, taking the company stock as a distribution instead of doing a 401k direct rollover would save you over 20% in taxes vs. rolling the stock over into an IRA account.
As you can see, the short-term taxes you avoid paying by doing a 401k direct rollover don’t always put you in a better long-term tax situation than had you taken the distribution and paid the taxes and potential penalty instead of simply executing the rollover.
(As is the case with all the information you’ll find on this website, the above is intended as general educational information and should not be taken to be investment or tax advice. Be sure to consult with a tax professional or financial planner before you decide if a 401k direct rollover is appropriate for your individual and specific circumstances.)