401k

You’re about to receive a distribution from your 401(k) plan, and you’re considering a rollover to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some pitfalls you’ll want to avoid.

1. Consider the pros and cons of a rollover. The first mistake some people make is failing to consider the pros and cons of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll your distribution over to your new employer’s 401(k) plan.

• Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be replicated in an IRA (or can’t be replicated at an equivalent cost).
• 401(k) plans offer virtually unlimited protection from your creditors under federal law (assuming the plan is covered by ERISA; solo 401(k)s are not), whereas federal law protects your IRAs from creditors only if you declare bankruptcy. Any IRA creditor protection outside of bankruptcy depends on your particular state’s law.
• 401(k) plans may allow employee loans.
• And most 401(k) plans don’t provide an annuity payout option, while some IRAs do.

2. Not every distribution can be rolled over to an IRA. For example, required minimum distributions can’t be rolled over. Neither can hardship withdrawals or certain periodic payments. Do so and you may have an excess contribution to deal with.

3. Use direct rollovers and avoid 60-day rollovers. While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than direct (trustee to trustee) rollovers. If the plan sends the money to you, it’s required to withhold 20% of the taxable amount. If you later want to roll the entire amount of the original distribution over to an IRA, you’ll need to use other sources to make up the 20% the plan withheld. In addition, there’s no need to taunt the rollover gods by risking inadvertent violation of the 60-day limit.

4. Remember the 10% penalty tax. Taxable distributions you receive from a 401(k) plan before age 59½ are normally subject to a 10% early distribution penalty, but a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during or after the year you turn age 55 (age 50 for qualified public safety employees). But this special rule doesn’t carry over to IRAs. If you roll your distribution over to an IRA, you’ll need to wait until age 59½ before you can withdraw those dollars from the IRA without the 10% penalty (unless another exception applies). So if you think you may need to use the funds before age 59½, a rollover to an IRA could be a costly mistake.

5. Learn about net unrealized appreciation (NUA). If your 401(k) plan distribution includes employer stock that’s appreciated over the years, rolling that stock over into an IRA could be a serious mistake. Normally, distributions from 401(k) plans are subject to ordinary income taxes. But a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan. Any appreciation in the stock generally receives more favorable long-term capital gains treatment, regardless of how long you’ve owned the stock. (Any additional appreciation after the stock is distributed to you is either long-term or short-term capital gains, depending on your holding period.) These special NUA rules don’t apply if you roll the stock over to an IRA.

6. And if you’re rolling over Roth 401(k) dollars to a Roth IRA… If your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, be aware that when you roll those dollars into your Roth IRA, they’ll now be subject to the Roth IRA’s five-year holding period, no matter how long those dollars were in the 401(k) plan. So, for example, if you establish your first Roth IRA to accept your rollover, you’ll have to wait five more years until your distribution from the Roth IRA will be qualified and tax-free.

No doubt you’ve seen headlines reporting that a particular stock index is up or down. But do you know what an index is, and how understanding the nuts and bolts of a specific index may be helpful to you?

An index is simply a way to measure and report the fluctuations of a pool of securities or a representative segment of a market. An index is developed by a company that sets specific criteria to determine which securities are included in the index based on factors such as a company’s size or location, or the liquidity of its stock. For example, the S&P 500 is an index made up of mostly large-cap U.S.-based companies that Standard & Poor’s considers to be leading representatives of a cross-section of industries.

The company that develops the index tracks the performance of its components and aggregates the data to produce a single figure that represents the index as a whole. Virtually every asset class is tracked by at least one index, but because of the size and variety of the stock market, there are more stock indexes than any other type. It’s important to note that the performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in an index.

Comparing apples to oranges

Since indexes encompass a wide range of securities, it’s important to know what segment of the market a particular index covers. For instance, a composite index follows a specific stock exchange. The Nasdaq Composite Index includes all the stocks listed on the Nasdaq market. Conversely, sector indexes track securities in a specific industry.

Even indexes that include the same securities may not operate in precisely the same way. Generally, indexes tend to be either price-weighted or market capitalization-weighted. If an index is price-weighted, such as the Dow Jones Industrial Average, the impact of each stock on the overall average is proportional to its price compared to other stocks in the index. With a price-weighted index, the highest-priced stocks would have the most impact on the average. For example, a 1 percentage point drop in the price of a stock selling for $80 per share would have more impact on the overall index’s performance than a 1 percentage point drop in the price of a stock that had been selling for $40 a share.

If an index is market capitalization-weighted or market value-weighted, such as the Nasdaq Composite Index or the S&P 500 Composite Index, the average of the index is adjusted to take into account the relative size of each company (its market cap) to reflect its importance to the index. Stocks with a larger market capitalization have a greater influence on how the index performs than stocks with a smaller market capitalization. For example, if the stock of a $10 billion market-cap company drops by 1 percentage point, it will drag down the index’s performance more than a 1 percentage point drop in the share price of a $1 billion market-cap company.

Though an index adheres to a set of guidelines for selection of the securities it includes, the company that oversees the index generally reviews the security selection periodically and may make occasional changes. For example, some indexes may rebalance if an individual security grows so large that it dominates the index. Others have a limit on how much of the index can be devoted to a particular sector or industry, and may rebalance if the proportion gets skewed.

Indexes are worth watching

Stock indexes can provide valuable information for the individual investor. If checked regularly, an index can provide information that may help you stay abreast of how the stock market in general, or a particular segment of it, is faring. However, understanding the differences between indexes and how each one works will help you make better use of the information they provide. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.

As a small-business owner, you probably either have, or have considered adopting, a 401(k) plan. 401(k) plans have assumed their starry status in the retirement universe because of the favorable tax benefits they provide to both employers and employees.

Most importantly, employers get an immediate tax deduction for contributions they make to their plans, and employees benefit from pre-tax contributions and tax-deferred, or in some cases tax-free, accumulation of investment earnings. But these tax benefits come at a cost. Employers must follow strict and often complicated laws in the Internal Revenue Code, and regulations promulgated by the government agencies charged with interpreting those laws–primarily the Internal Revenue Service and the Department of Labor.

Tax effects of plan disqualification

Plans that comply with the tax rules are said to be “qualified” and therefore entitled to their favorable tax status. But plans that run afoul of the rules (for example, by improperly excluding participants, missing contributions, or failing discrimination tests) can become “disqualified.” The potential consequences of disqualification are severe:

• Employees are taxed on their pretax contributions in the year those contributions are made to the plan, rather than the year the contributions are paid from the plan.
• In general, employees are taxed on employer contributions, and plan investment earnings, in the year they vest, rather than the year benefits are paid; in certain cases, highly paid employees are taxed on the entire value of their accounts (to the extent not already taxed).
• Employers take deductions for plan contributions in the year their employees vest in that contribution, rather than the year the employer made the contributions to the plan.
  The plan trust must pay taxes on its earnings.
• Distributions from the plan are ineligible for special tax treatment and cannot be rolled over tax free to IRAs or other qualified employer plans.

Even worse, a plan may be disqualified retroactively if the plan defect occurred in a prior year. This means that employers and employees would likely need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for underreporting income in those prior years could also be imposed. And while the IRS generally can’t go back more than three years (six years if there was a substantial underreporting of income) to collect taxes for any earlier year, the IRS might require correction of those closed years if an employer seeks to requalify its plan.

IRS to the rescue

Luckily, the IRS has adopted several programs that may help you avoid the potentially disastrous consequences of disqualification.

The Self-Correction Program, or SCP, is generally the program of choice if you’re eligible. This program allows you to self-correct many plan errors–and preserve the tax-favored status of your plan–without contacting the IRS or paying a fee, and there are no application or reporting requirements. “Correction” generally means that the plan and participants must be placed in the same position they would have been if the failure had not occurred. The program is available for any errors that occur when you don’t follow the written terms of your plan. You can correct insignificant errors at any time. And you can even self-correct significant operational errors if you act promptly. (“Egregious” errors can’t be corrected using SCP.)

If you’re not eligible for SCP (or if you’d like the comfort of IRS approval of your corrections), the next step is the Voluntary Correction Program (VCP). This program is available only if your plan is not being audited. You must submit an application to the IRS describing the plan failure(s), describe how you intend to correct those failures, and detail the administrative changes you intend to adopt to avoid those failures occurring in the future. You must also pay a compliance fee, ranging from a few hundred dollars to $25,000, depending on the nature of the failure and the number of plan participants. If your application is approved, the IRS will generally agree not to disqualify your plan because of the disclosed failures if you complete the approved corrections within 150 days.

If you don’t use SCP or VCP to voluntarily correct plan errors, and the IRS discovers the failures itself (for example, during a plan audit), you may still be able to preserve your plan’s tax benefits by using the Audit Closing Agreement Program (Audit CAP). Under this program, you must correct the plan failures, enter into a “Closing Agreement” with the IRS, and pay a penalty equal to a negotiated percentage of the additional taxes that would have been payable had the plan been disqualified.

The qualified plan rules are complicated. Working with a retirement plan professional can help you avoid mistakes that could lead to the ultimate penalty of disqualification.