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Self Directed Retirement Plans Blog

Pension Rollover to IRA: Rules, Pros, Cons and More

Pension Rollover to IRA: Rules, Pros, Cons and More

Can you roll over a pension plan into an IRA? Yes, provided it meets two criteria: the pension plan is a “qualified employee plan” (if you’ve been deferring tax on your contributions, your plan is most likely a qualified plan), and you must have left the company or your employer intends to close the pension plan.

What to Consider Before a Pension Rollover to an IRA?

There are several factors you should consider when deciding to roll over your pension plan to an IRA.

  1. What are your investment goals, time horizons, and risk tolerance?
    An IRA offers a wide variety of investment options that a company pension plan doesn’t. You are not limited to stocks, mutual funds, and bonds; you can choose a wide variety, including real estate and precious metals, among others. You can decide on the investment types after considering your investment goals, risk tolerance, and time horizon.

  2. When do you plan to retire?
    A company pension plan allows you to take a distribution from your retirement account at age 55 under certain circumstances. However, if you do a rollover to an IRA, you are now subject to IRA rules meaning you can take a penalty-free distribution only after you are 59 ½. If you take it before 59 ½, you will have to pay a 10% penalty on the distribution.

Does your company pension plan also include the distribution of the company’s stock?

If your pension plan includes company stock, you may want to take the distribution of the company stock only after you retire and when you are in a lower tax bracket. If you take a distribution before you are 59 ½, you’ll have to pay a 10% penalty and tax on your distribution. If you take a distribution after 59 ½, the 10% penalty will be excluded, but your distribution will be taxed as regular income.

Pros and Cons of Rolling Over a Pension Into an IRA

Rolling Over a Pension Into an IRA: The Pros

Some of the biggest benefits of rolling over your pension plan into an IRA include:

  1. You have a vast range of investment options.
    An IRA gives you the freedom to invest in a wide range of traditional investments such as stocks, mutual funds, bonds, index funds, etc., which are not available with pension plans. You can also look at nontraditional (alternative) investments such as a real estate for the first time. You can choose the investments according to your risk appetite and preference.

  2. You have better withdrawal flexibility.
    Pension plans usually have limitations on when and how to make the withdrawal. However, a rollover of your pension plan into an IRA gives you greater flexibility. You can withdraw funds before retirement and as many times as you want. However, withdrawing before retirement can attract taxes and penalties.

  3. You avoid paying taxes.
    Rolling over your pension directly to a traditional IRA will not attract taxes or penalties on the distribution. However, if you roll over to a Roth IRA, it will be taxed, but the withdrawals from a Roth IRA are tax-free.

  4. You have greater control
    With an IRA, you have greater control over your savings. You have the choice to decide where to open an IRA and figure out the best asset allocation in your portfolio based on your risk profile. Even if you change jobs, you can keep your IRA account while continuing to save for your retirement.

Rolling Over a Pension Into an IRA: The Cons

Although the benefits are many, the rollover of your pension plan into an IRA has a few disadvantages as follows:

  1. You don’t have an option to take a personal loan.
    When you roll over your pension to an IRA, you lose the ability to borrow from your retirement savings. If you are in urgent need of money, you are left with the option of making an early withdrawal, which attracts a 10% penalty plus tax.

  2. You cannot take a distribution before 59 ½.
    With the pension plans, you can take a distribution without penalty when you retire or leave the company at age 55. But when you roll over your pension plan to an IRA, you must wait until you reach 59 ½ to take a penalty-free distribution. If you take a distribution before age 59 ½, you must pay a 10% penalty on the withdrawn amount, losing a significant amount of your retirement money.

  3. You lose creditor protection.
    Your retirement savings in a retirement plan are creditor protected. This means that your creditors cannot take your funds in bankruptcy situations or during collection. However, when you roll over the funds into an IRA, you lose that protection.

How to Rollover a Pension Plan

Some of the key methods of a rollover to an IRA include:

  1. Direct Method

    The rollover into an IRA is extremely simple if you do it through the direct method. You just :

    1. Set up an IRA.
    2. Request your employer to prepare the paperwork required to start the rollover process.
    3. Request your IRA custodian to initiate a “direct” rollover. This ensures that money is directly transferred from one account to the other.
  2. Indirect Method

    In the indirect method, you have the amount in the pension plan is directly paid to you. However, you have 60 days to redeposit the money into an IRA; otherwise, it will be considered as a distribution, and you will be charged a penalty of 10%, plus tax if you are under 55. Moreover, the plan administrator will withhold 20% of the account balance as tax to be sent to the IRS. This money is later credited as a tax credit.

  3. Lump Sum Payout

    If you are 55 or older when the plan is closed, or you leave the company, you can take the pension as a lump sum distribution. This will not trigger the 10% early withdrawal penalty. However, the distribution will be considered as ordinary income, and tax will be charged the year you take the money.

Benefits of Rolling Over to a Self-Directed IRA

Here are a few reasons why a self-directed IRA is a great option if you need to roll over your pension or any eligible 401(k):

  • Better investment options, such as real estate, startups, peer-to-peer lending, etc.
  • When you own a wide variety of asset classes, you improve your ability to withstand market volatility.
  • You are in control of your investment portfolio.

If done correctly, rollovers of pension plans are tax neutral. If done incorrectly, there’s a risk of the IRS taking a slice of your pension pie. If you want to do it right, get in touch with a financial expert who can do the rollover correctly with reduced tax implications.

How Can I Get My 401(K) Money Without Paying Taxes?

How Can I Get My 401(K) Money Without Paying Taxes?

How are 401(k) withdrawals taxed?

When you take distributions from a regular or traditional 401(k), they are treated as normal income and subject to income tax. Since your contributions to traditional 401(k) were paid with pre-tax dollars, you are liable to pay taxes when you start taking your distributions.

When you withdraw money from your traditional 401(k), the IRS considers the withdrawal as ordinary income and taxed as such. Therefore, the tax you pay on your withdrawal will depend on your tax bracket; the higher the distribution, the higher the tax payable will be. Moreover, if you withdraw from your 401(k) before you reach 59 ½ years, you may also be charged a 10% penalty on the distribution.

However, with a Roth 401(k), your distributions have a different tax treatment. Since your contributions to a Roth 401(k) are made with after-tax dollars, it’s unlikely that you’ll be taxed on your distributions, that is, if it’s a qualified distribution. A qualified Roth 401(k) distribution is when:

  • your Roth account has sufficiently “aged” – it should meet the five-year aging rule
  • you are old enough to make a withdrawal without a penalty – you can receive a tax-free distribution treatment once you reach the age of 59½

How can I withdraw from my 401(k) without paying taxes?

If you want to get your 401(k) money without paying taxes, here are a few strategies that you can use to reduce or eliminate the tax burden on your 401(k) withdrawals. Read on.

  1. Keep your tax bracket low.

    Keep your taxable income in a lower tax bracket when you take 401(k) withdrawals to reduce your tax bill. You can do this by withdrawing from your 401(k) up to your upper limit. This will help you avoid falling into the next tax bracket, which has a higher tax rate. For example, if you and your spouse’s income is below $81,050 (12% tax bracket), an income above $81,051 pushes you into a higher tax bracket (22% tax rate), resulting in a higher tax bill.

    You can limit the 401(k)-withdrawal amount by taking a combination of 401(k) and other sources such as your cash savings or Roth savings.

  2. Consider moving your savings to Roth.

    If you anticipate that your earnings in retirement will fall in a higher tax bracket, consider moving the savings to a Roth account. This can be done at once or over a period of years – therefore speading the tax burden. A lot of people use this multi year method to co-incide wth the five year rule. Since after-tax dollars fund Roth, your withdrawals in retirement will be free of tax.

  3. Consider borrowing from a 401(k) instead of withdrawing.

    Most 401(k) plans allow employees to take a loan from their 401(k) balance, up to 50% of their vested account balance or a maximum limit of $50,000, before they attain retirement age. The borrowed amount is not subjected to ordinary income and doesn’t attract an early withdrawal penalty if it follows the IRS guidelines. However, the borrower must repay the loan within five years by making regular and equal loan payments for the term of the loan. Any amount not paid in the five-year timeframe will be considered a deemed distribution and subjet to income tax and depending upon the person’s age, also subject to the 10% IRS penalty.

  4. Defer taking your Social Security benefits

    If you have already made a 401(k) withdrawal, consider deferring your Social Security benefits to ensure that you remain in a lower tax bracket. If you take both distributions at the same time, your taxable income increases, making your tax bill higher. Also, every year you defer taking your Social Security payments increases your benefit by approximately 8%.

  5. Avoid early withdrawal penalty.

    When you withdraw from your 401(k) before age 59 ½, you are subjected to a 10% early withdrawal penalty plus income tax. Even if you qualify for a penalty-free 401(k) withdrawal ( if you leave your current employer at age 55 or later), your distribution will still be considered as ordinary income, and you will be taxed. So try to avoid making an early withdrawal from your 401(k).

  6. Donate your distribution to a qualifying charity.

    If you are 72 years (soon to be changed to 73)you must take the required minimum distributions (RMDs) from your 401(k). If you don’t need the RMDs to pay for your expenses, you can avoid paying tax by rolling over your funds to an IRA and donating the distribution to a qualifying charity.

  7. Rollover your 401(k) into another 401(k) or IRA.

    If you are still working, you need to know that you don’t have to take 401(k) distributions at your current employer. But if you have old 401(k)s with your previous employers, you will have take RMDs from these accounts once you reach age 72. If you want to avoid taking RMDs without being taxed, roll over your 401(k)s with your previous employers into your current 401(k) before you turn 72. This way, you can defer taxable income until retirement. By then, your distributions may fall in a lower tax bracket, if you don’t have any earned income.

  8. Get disaster relief.

    When disaster strikes, the IRS offers 401(k) distributions relief to people residing in areas prone to disasters like tornadoes, hurricanes, and other forms of natural disasters. If you are below 59 ½ years and make an early 401(k) withdrawal, you can get a 10% early withdrawal penalty waiver.

    The IRS also offers a waiver in case of hardship withdrawals such as putting a downpayment for your primary residence mortgage, difficulty in paying college tuition, job loss, etc. For example, during the COVID-19 pandemic, the CARES act allowed people to take a hardship distribution of up to $100,000. This withdrawal did not incur the 10% penalty for early withdrawals.

  9. Consider tax-loss harvesting.

    Tax-loss harvesting is selling underperforming securities from your investment portfolio. The losses you incur on your securities offset the taxes on your 401(k) distribution. If you exercise this correctly, tax-loss harvesting can offset all or some of your tax burden generated through a 401(k) withdrawal.

The Bottom Line

These are some very good strategies for avoiding or reducing income taxes on your 401(k) withdrawal. However, these are advanced strategies used by financial experts to reduce the tax burden of their clients. If you want to implement these strategies, don’t go ahead unless you have a high degree of financial and tax knowledge. The best thing you could do is seek help from a financial expert to ensure that you are using the right strategy to reduce or avoid your tax bills.