Maybe you’re leaving your first job and have a few thousand dollars in a 401(k) and have just received a letter asking what you want to do with it. Or maybe you weren’t even given a choice — it is common for small 401(k) balances to be automatically cashed out after you leave a company. It may be tempting to stick that money in your checking account, but you will end up paying a 10% penalty on top income taxes at the end of the year if you do that.
That seed could make a great start to your retirement investing, if you know how to plant it. If you receive a disbursement check, you can deposit it into an IRA within 60 days and it won’t be considered a withdrawal or subject to taxes and penalties. But there are some pitfalls to avoid:
To deal with Pitfall #1, if you had $1500 in your 401(k) and are issued a check for $1100, you can make up the $400 out of your own bank account when making the IRA deposit. The extra $400 will be refunded to you when you file your tax return.
Or, if your 401(k) balance is not sufficient to open an IRA in the first place, you can take this as an opportunity to set aside a bit more money for retirement and top up the rollover to the amount necessary to open a new account.
Assuming you are rolling over from a traditional 401(k), you will initially be putting this money into a traditional IRA. However, if you are a young person in a low tax bracket, or even a student working only part of the year, this can also be a good opportunity to convert that IRA to a Roth IRA. This will cause whatever amount you convert to be added to your taxable income for the year. But if you only made $5k, you will still be below the threshold where you incur any taxes. Even if you are in the 10% or 15% tax bracket, this can still be a great chance to jumpstart your tax diversification for your retirement savings.
Remember, you don’t have to do this alone. Working with a fee-only financial planner can be the perfect way to educate yourself about your options, roll over accounts correctly to avoid penalties, and more. Feel free to contact me today, and we can discuss your unique situation.