Financial Focus: Changing jobs or retiring? Consider IRA rollover

By Yvonne Catton

In the near future, are you going to change jobs or retire? If so, then you’ll have a lot of things to think about. And one of the most important considerations is what to do with the money you’ve accumulated in your employer’s 401(k) plan. While you have a few options, your best choice may be to roll over your 401(k) money into an IRA — so you’ll want to know, in advance, what’s involved in this move.

By rolling over the taxable portion of your 401(k) — your pre-tax contributions, employer contributions and all earnings — into a new or existing IRA, you’ll gain some key advantages. First, you’ll avoid all immediate taxes and penalties. Second, you’ll continue to benefit from tax deferral. And third, IRAs offer you a wide variety of investment options.

Eventually, though, you’ll have to decide what to do with your IRA. You can start taking withdrawals at age 59-1/2 without having to pay a 10 percent penalty tax. But suppose you’ve built up a considerable balance in your traditional IRA, and you don’t think you’ll need to use it all to help pay for your retirement. Can you pass on your IRA’s tax deferral to your children?

Yes, you can — through the concept of the “stretch’’ or “multi-generational’’ IRA. To understand how the stretch IRA works, you need to know one of the rules governing traditional IRAs. Specifically, you have to start taking “required minimum distributions’’ at age 70-1/2. In recent years, the IRS changed the life expectancy factors used to determine your required minimum distribution calculations. Consequently, you can now take out smaller amounts of money from your IRA, which allows you to extend the number of years your IRA money has the potential to grow tax-deferred.

Obviously, the revised life expectancy rules will positively affect how much of your IRA money you can leave to your children. But the rule changes also permit your children, once they inherit your IRA, to base their minimum required distributions on their life expectancies. So, if they are in their early middle-aged years when they receive your IRA, they can take out relatively small amounts, thereby avoiding big tax hits. And, if their situation allows, they can then leave the IRA to their children, who can continue to enjoy the benefits of tax deferral.

Rollover to Roth IRA

Until recently, you couldn’t roll over a 401(k) directly to a Roth IRA — first, you had to roll over the 401(k) to a traditional IRA and then convert the traditional IRA to a Roth and pay tax on the conversion.

But new tax laws allow you to make direct rollovers to a Roth IRA, starting in 2008. You’ll still have to pay taxes on the converted amount, but you — and your children or grandchildren — might come out ahead in the long run, because Roth IRA earnings have the potential to grow tax-free, provided certain requirements are met. You’ll need to consult with your tax advisor to make sure you are eligible to open a Roth IRA.

Keep Your 401(k) Working for You

Before you change jobs or retire, consult with your financial adviser and tax professional on whether an IRA rollover makes sense for you. You worked hard for your 401(k) funds, so keep them working for you.