You’ve been very careful with your 401k plan. You thought you did everything right.  But ask yourself three questions:  

1. Are you planning to retire or leave your company after reaching age 55?
2. Are you planning to roll over your 401k to an IRA?
3. Will you make withdrawals from your 401k funds before age 59 ½? 

If your answer to all three questions is yes, there’s a chance you’ll make 401k Critical Mistake #10 in THE 10 CRITICAL 401k MISTAKES series.

How so? Read on!

Because of the potential for greater diversification and administrative flexibility with IRAs, it’s very common to roll over your 401k to an IRA after retirement or after your leave your company. 401k Critical Mistake #10 can happen when you roll over your 401k to an IRA too early and unnecessarily trigger the potential for a 10% IRS penalty on IRA withdrawals made before age 59 ½.

Let’s look at a case study to illustrate this mistake.

• You retire or leave your company after turning 55.
• 401k balance: $1,000,000
• You believe you will not need to withdraw any of these funds until after you turn 59 ½.
• Seeking greater diversification and administrative flexibility, you roll over your 401k to an IRA.
• Due to unforeseen events, you now require an annual withdrawal from your IRA of $20,000 beginning at age 55.
• Withdrawals from IRAs are generally taxed as ordinary income.  If you’re in the 37% tax bracket, this means for each withdrawal you’ll owe 37% of 20,000, or $7,400 in taxes.
• Withdrawals from IRAs prior to age 59 ½ generally trigger the 10% IRS penalty for early withdrawal. So, in addition to the income tax, you’ll owe 10% of 20,000, or $2,000 in penalties.

Many people rush to roll over their 401k to an IRA after they retire or leave their company. To avoid 401k Critical Mistake #10, it’s important to know that the 10% IRS penalty for early withdrawal from a 401k contains an important exception that an early withdrawal from an IRA does not contain.

This exception has a name. It’s called “The Rule of 55”. After you turn 55, the “Rule of 55” allows you to avoid paying the 10% IRS early withdrawal penalty on 401k withdrawals if you retire or leave your company.

If you plan to retire or leave your company after reaching age 55, and desire to roll over your 401k to an IRA, consider the following strategy:

1. Estimate the amount you will need to withdraw from your 401k funds prior to age 59 ½.  Leave this amount in your 401k—and maybe a little bit more.  Then roll over the rest of your 401k to an IRA. 
2. If you don’t plan to take withdrawals prior to 59 ½, but acknowledge that doing so is possible, consider leaving a substantial amount in your 401k and roll over the rest of your 401k to an IRA.  If you unexpectedly need to make withdrawals before age 59 ½, you at least have some funds in the 401k not subject to the 10% IRS penalty.
3. Prior to age 59 ½, take withdrawals, as needed, from your 401k.  Do not take withdrawals from your IRA prior to 59 ½. 
4. Roll over any remaining balance in your 401k to your IRA after reaching age 59 ½.

The goal of this hybrid approach of leaving a portion of your funds in your 401k and rolling over the rest to an IRA is to enjoy the potential benefits of IRAs while decreasing the potential tax burden. You’ll still pay income taxes on 401k withdrawals but leaving funds in your 401k may allow these withdrawals before age 59 ½ to avoid the 10% IRS penalty.

• If you plan to retire or leave your company after reaching age 55, and plan to roll over your 401k to an IRA before age 59 ½, discuss with your financial or tax advisor the withdrawals you plan to make prior to age 59 ½.  Determine how much to leave in your 401k and how much to roll over to an IRA.
• Withdrawing funds from your 401k, or rolling over your 401k to an IRA, may affect your eligibility to implement a potential tax strategy worthy of consideration called “Net Unrealized Appreciation.”  To learn more, check out 401K Critical Mistake #3: Have Employer Stock in 401k?  Do This Before Rollover to IRA

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April 2023

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