Imagine how you would feel if you were on a sinking cruise ship and couldn’t get off because there weren’t any life jackets or backup boats. Now ask yourself, if you were going to potentially face this scenario, when would you want to know about it?
If you have money in a 401(k) plan, they may impose a blackout period. During a blackout, which occurs when a company decides to make changes to the record keeper, participants are locked out of making investment changes to their plan. While blackouts don’t happen frequently, they can last a few weeks or even several months in extreme cases. Fortunately, many people with a 401(k) plan may avoid this potential issue by using what is called an in-service distribution.
Is an in-service distribution right for you? First, if you are still employed, determine if your company retirement plan allows for in-service distributions. Many plans do for people over the age of 59 1/2 or if they meet certain other requirements. If you qualify, consider the advantages and disadvantages of potentially rolling over your money to an individual retirement account (IRA), which wouldn’t be affected by a blackout, and also increases the number of investment options available to you. With more options available, you can better control the fees you pay instead of being at the mercy of paying whatever fees your work-sponsored retirement plan charges.
Recently, someone was in our office for a 3-Step Retirement Review and we found they were paying over 4% in total fees in their 403(b) (similar to a 401(k), but for a nonprofit) per year! It is difficult to get ahead if your performance is weighed down with fees that are that high. On the other hand, we’ve also seen examples where 401(k) fees are quite low and investment options quite good. In these cases, we typically tell people to keep money in their 401(k) unless tax planning makes sense for their situation.
With the current tax rates set to expire after 2024 (because of a sunset provision in the Trump tax cuts), action now while tax rates are lower may be a reason to consider a rollover to an IRA. Money in an IRA can be converted to a Roth, either all at once or slowly each year, which could potentially save thousands in taxes over time. With a Roth conversion, you pay taxes on the amount transferred to the Roth now at the current historically low tax rates, and then you’ll never have to pay taxes on the withdrawals from the Roth or its growth in the future, as long as IRS rules are adhered to.
Even if tax rates don’t rise, a conversion could still save a retiree a significant amount in taxes in retirement. Taxes work very differently in retirement, and it’s possible you may pay a higher effective tax rate on 401(k) or IRA withdrawals later even if your income in retirement is lower. While this may seem completely counterintuitive, it is an unfortunate reality that some retirees may face as outlined in our previous two part article series, “Getting the Taxman Out of Your Retirement.” (You can reread those articles at RetireTopeka.com/blog).
To see how much, if any, of your money it makes sense to convert to a Roth, you should seek out the guidance of a professional who can run a ‘tax map’ to show you what your taxes are likely to be in the future versus what they would be now. This analysis should be run each year to calculate how much can be converted now at a lower tax rate than what you would likely pay in the future. This can sometimes be a small amount, but it can also be a larger amount, depending on your situation.
If you are considering making such a conversion from a 401(k) plan to a traditional IRA or Roth IRA, you should also look at the impact of the recently passed SECURE Act. Now most non-spousal beneficiaries must withdraw and pay any taxes owed on an inherited account within 10 years of an owner’s death. If left in a 401(k) or IRA, the tax burden could be significantly higher. The Congressional Research Service estimates that over just the next 10 years, this is going to generate $15.7 billion in additional taxation on inherited 401(k)s and IRAs, so considering converting to a Roth ahead of time while there are temporary tax cuts is even more appealing than ever.
If you’re not sure if you can take an in-service distribution from your 401(k), 403(b), 457, or TSP plan or if you are unsure if you could potentially save thousands in taxes by converting to a Roth, consider having your personal situation reviewed by an independent investment professional who is familiar with the Pension Provision Act and advanced tax reduction planning. Given the results of last year’s election, the tax code may change even before 2024, so planning this year may be even more important. Actions taken this year (or inaction taken this year) could be one of the most impactful things in determining how many individuals will live out their retirement years and the taxes they will pay in the future.
Material discussed is meant for general/informational purposes and is not intended to be used as the sole basis for any financial decisions, nor be construed as advice to meet your particular needs. Please consult a financial professional for further information.
Investment advisory services offered through Next Generation Investing, LLC.
Securities offered through World Equity Group, Inc. member FINRA and SIPC.
Next Generation Investing, LLC, & The Retirement Team are not owned or controlled by World Equity Group.
Insurance and annuities offered through Ryan Shumaker, KS Insurance License #10359614.
Ryan can be contacted at 785-228-0222 or RetireTopeka.com.
Other great articles about retirement, investing, and tax reduction can be seen at RetireTopeka.com/blog.