As a wealth advisor, you’ll be working with high-net-worth clients assisting them in choosing the right type of accounts for their retirement funds.
Benefits of Company 401(k)
One benefit of recommending that your client leave money in a company Internal Revenue Code Section 401(k) plan (401(k)) rather than rolling it into an individual retirement account (IRA) is that there might not be any required minimum distributions (RMDs) if the account owner is still working and not a 5% owner of the business that provides the plan. Clients should check with their plan administrator, as some plans require that RMDs begin at age 72, even if still employed. Generally, account holders must start taking distributions from their retirement accounts at age 72 if they were born after June 30, 1949. The RMDs at age 72 apply only to traditional IRAs and not to Roth IRAs. The SECURE Act repealed the cap on making contributions once you reached age 70 ½ for traditional IRAs. You can now make contributions if you are still working and receiving earned income regardless of your age.
Also, while some plan costs are higher than one might expect, administrative costs may be less expensive in the company 401(k). A review of the underlying funds expense ratio plus the plan sponsor fees is an important factor to determine if it’s more beneficial to rollover a 401(k) to an IRA or to keep the 401(k) with a previous employer.
A third benefit of leaving money in a company 401(k) is that qualified retirement plans are protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by creditors. An exception applies to IRS levies, as there is generally no protection from those. Only qualified plans set up under ERISA receive full protection. For example, Internal Revenue Code Section 403(b) plans offered by state or local governments probably aren’t set up under ERISA and might not qualify for federal protection.
Benefits of IRAs
IRAs also aren’t protected by ERISA, but they do have some protection under federal bankruptcy law. However, any amount rolled over from a qualified plan to an IRA is protected from creditors under federal bankruptcy law. Amounts in IRAs that are not rollovers from 401(k) plans and other qualified plans are protected up to $1 million indexed for inflation every three years. Outside of that, protection from creditors is based on State law.
The major drawback to your clients leaving a 401(k) plan with their previous employer is that they may be limited to their funds menu if the plan does not allow the option of a self-directed brokerage account within the company’s 401(k) plan. Should your clients decide on an IRA rollover, their investment choices would be unlimited.
There are no tax consequences when rolling over a 401(k) directly into an IRA or indirectly within 60 days, but this rollover must be reported on your client’s individual tax return. When converting a 401(k) to a Roth 401(k) or when converting a traditional IRA to a Roth IRA, your client will need to pay taxes on any pre-tax amount included in the rollover. Roth IRAs grow tax deferred, and distributions are tax free from a Roth IRA as long as the owner has funded a Roth IRA for at least five years and is at least age 59 ½ or disabled when the distribution is made.
Considering that we’re currently in a low tax environment and income tax rates will likely be higher in 2026, or potentially sooner depending on the results of the presidential election, the Roth IRA conversion is appealing to a lot of taxpayers. Additionally, because the Coronavirus Aid, Relief, and Economic Security Act eliminated RMDs for 2020, your clients can withdraw RMD amounts or more than they would typically have taken for 2020, roll this amount into a Roth IRA and pay taxes on those conversions. Rolling over 2020 RMDs into Roth IRAs will reduce your clients’ future RMDs and the amount of taxes they’ll need to pay in the future because there are no RMDs for Roth IRA owners.
Clients with high balances in their IRAs and their beneficiaries are the ones most affected by the Setting Every Community Up for Retirement Enhancement Act’s 10-year rule, which require an inherited IRA to be fully distributed by the end of the 10th year following the year the account owner dies. An exception applies to those who qualify to be eligible designated beneficiaries, allowing them to take distributions over their life expectancies. Because of this rule, an IRA might not be the best asset to pass on to beneficiaries. A better option might be to spend the money from IRAs and leave assets from other accounts to beneficiaries. For example, additional life insurance and/or Roth IRA conversions are better assets to leave to beneficiaries because they’re not taxable to beneficiaries. If your clients convert their traditional IRAs to Roth IRAs, the beneficiaries can wait to take distributions until the end of the 10th year, during which time the Roth IRAs continue to grow tax-deferred. Additionally, beneficiaries won’t have to pay any taxes on the distributions as long as the distributions are taken at least five years after the owners funded the Roth IRAs .
As you can see, there are options to consider and these are only a few. With careful consideration and consultations regarding the current tax implications, you’ll be able to help your clients make the right choices for themselves and their beneficiaries.
Sara Rabi is a partner at Marks Paneth LLP in New York City