What you should know about 401(k) rollovers

Q: I plan to retire soon. I have a 401(k) retirement account with my employer, and want to use this account to supplement my Social Security and investment income during retirement. Should I roll the account over to an IRA? How? What concerns should I have?

A: First of all, if you withdraw money from the 401 (k) account and don't roll it over you will pay tax on it. And if you are under 59½ you will pay an additional 10 percent early withdrawal penalty unless you meet certain exceptions, which I will tell you about next week. Rolling your 401(k) into an IRA account is usually a good idea. Many 401(k) plans have hidden costs that put a drag on performance and offer a limited number of investment options.

If you roll over your 401(k) account to an IRA at a brokerage firm you will have access to a better selection of investments including stocks, bonds, ETFs, and mutual funds. You will then be positioned to manage your investments for income and/or growth.

The only drawback to moving from a 401(k) to an IRA that I am aware of is that you may lose some protection from creditors. Federal ERISA rules protect 401(k) plans (but not all IRA accounts) from creditors should you ever go into bankruptcy.

However, California law does offer some protection for private retirement plans, including IRAs. If you anticipate credit or bankruptcy problems you should consult your attorney before you roll over your 401(k).

Your company's 401(k) plan administrator

will provide you with the forms you need to initiate the rollover. Work with your financial adviser, or open an IRA account with a brokerage firm (if you don't already have one) and instruct the plan administrator to transfer the funds directly from the company plan to the IRA account.

If you have company stock inside your 401(k) account, you need to be careful and work closely with your adviser. The IRS offers favorable capital gains tax treatment on the gain in value of the company stock that you have accumulated inside your retirement plan. But you will lose this favorable tax treatment if you include the company stock in the rollover to an IRA account.

By moving the stock to a separate non-IRA account you can take advantage of "net unrealized appreciation" (NUA), which is the value of the stock on the date of distribution — the day you take it from the 401(k) minus its value on the date it was purchased in your 401(k). You will pay long-term capital gains tax (currently capped at a 15 percent federal tax rate) on the NUA when you sell the stock (compared to the higher ordinary income tax rates you would pay if you sold it in your IRA account and then withdrew the proceeds).

You will also pay capital gains tax on any appreciation in the price of the stock between the distribution date and the day you sell it. Work closely with your adviser to review your options. You may have to pay some tax at the time you take distribution of the company stock — at ordinary income tax rates — to save tax later when you sell the stock.

Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or ken@montereypw.com