How the 401(k)-IRA Rollover Thought Process Works

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.

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.