401(k) rollovers – make sure you know all the rules before you start

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Here’s why:

A 56 year old attorney left his job.  Soon thereafter, he did a 401(k) rollover into a SEP IRA.  The next year (age 57), he took $240,000 out of the SEP IRA account.  Because he took the money out of a SEP IRA before age 59 ½, he had to pay the 10% early withdrawal penalty, or $24,000 in taxes.  The fact that the money started in a 401(k) account, is irrelevant (Kim, 7th Cir).

Unknown to the attorney (and his financial planner if he had one) is that he could have avoided the 10% penalty.  One of the exceptions to the 10% early withdrawal penalty for money taken from retirement accounts is that if you are over 55 and separate from your employer, you can withdraw the money from your 401(k) plan without paying the 10% penalty.  However, once the attorney executed the 401(k) rollover to the SEP IRA, he lost the ability to take advantage of that rule.

Alternatively, he may have been able to perform a 72(t) withdrawal, also known as Substantially Equal Periodic Payments or SEPP.  The rules on this are quite complex, but with the appropriate advice and if his circumstances allowed for it, he may have been able to use these rules to avoid the 10% early withdrawal penalty and lower his ordinary tax rates by taking out less money each year.

Another option could have been better upfront planning.  He may have been able to save some of the money outside of tax deferred accounts, decreased his spending for a few years prior to the large expense and borrowed some of the money through a home equity loan (at perhaps 4% instead of paying the 10% penalty) to avoid the whole situation.

Jeff’s recommendation…before doing anything that involves a large amount of money, talk with an independent financial professional who has no conflicts of interest and is a fiduciary when giving you financial advice.


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