A 401k rollover requires that 20 percent of the amount being rolled over be withheld for taxes, even though the account owner still has to deposit 100 percent of the amount within 60 days to avoid taxes and penalties.

A 401k transfer requires no withholding and moves the funds tax-free.

An IRA rollover gives the account owner 60 days to deposit any rolled over funds into a new IRA account. IRS rules limit each taxpayer to only one rollover per year.

An IRA transfer moves the money directly to a new qualified retirement plan account with no delays and with no one per year limits.

FBO – For Benefit Of

A trustee-to-trustee transfer occurs when you move funds from one qualified retirement plan custodian to another without ever having control of the money. The easiest way for the IRA owner to do this is electronically with the the financial institutions moving the money from one account to the other by computer. However, it isn’t the only way it is done.

Some IRA banks and brokerages send the account owner a check. This is easier on them because they don’t have to interface their account systems with another bank’s account systems. If they make the check payable to you, however, you have taken control of the funds and started a rollover, not a transfer.

It all comes down to three little letters on the check: FBO.

FBO stands for "for benefit of" and it is a method of writing a check to you, without actually writing a check to you.

An FBO check is a third-party check. In this case, the check will be made out to the new IRA custodian, usually a bank or brokerage firm, for your benefit. That makes all the difference in the world.

As the FBO on the check, you do not endorse the check. You cannot deposit the check in your bank account. You cannot cash the check. The check is not made out to you. It is made out to Vanguard or Fidelity or whoever is your new IRA company.

The FBO means that you will eventually be the final recipient of the funds. Merrill Lynch can’t just cash your check either. That would violate the FBO portion of the payee. However, you do not get control of the funds until … they are already in your IRA. Viola! Trustee-to-trustee transfer, and not a rollover!

If you are trying to do a transfer and not a rollover and you get a check from your old 401k company or IRA company that is made out directly to you (without the FBO) return the check immediately. Cashing the check or depositing it is the worst thing you can do because that gives you control over the funds and turns your transaction into a rollover.

Your new retirement plan bank or brokerage should help guide you through the process, but it is always smart to know what is going on before you get started.

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Difference Between a Rollover and a Transfer originally published at Finance Gourmet

What Does Pre-Tax Mean?

Pre-tax dollars is a phrase that is often used in conjunction with retirement planning and 401k contributions. In fact, one of the benefits of a 401k plan is that contributions are made with pre-tax dollars. But, what is the definition of pre-tax dollars, anyway?

When an employee gets paid, there are numerous deductions that get taken out of their paycheck. These payroll deductions range from income tax withholding to FICA taxes to voluntary contributions for things like health insurance or cafeteria plans (Section 125 plans).

Some of the deductions from your paycheck, like federal tax withholding, are computed based on how much you are paid. Pre-tax means that the deduction occurs before that withholding is calculated. This is why many financial writers and other financial experts point out that contributing to your 401k plan doesn’t actually reduce your paycheck by the full amount.

It is worth noting that both Medicare taxes and Social Security taxes are not reduced by pre-tax contributions to your 401k. That is why there is separate entry for FICA Wages or Social Security Wages on your paystub or W2 Form.

How Pre-Tax Contributions Affect Your Taxes

The impact of pre-tax contributions on your taxes goes beyond just how it changes calculations on your paycheck. Pre-tax 401k deferrals are also not included in the taxable wages reported on Form W-2.

W-2 wages are used as the starting point for calculating your Adjusted Gross Income and Modified Adjusted Gross Income (MAGI). These two numbers form the basis of your taxable income. Just as importantly, these numbers also determine your eligibility for numerous tax deductions and tax credits, as well eligibility for tax items with income limits.

For example, contributing to your 401k reduces the your income for purposes of determining whether an IRA contribution is deductible or whether you meet the income limits for Roth IRA contributions.  It also can affect which tax bracket you are in. Contribute enough to your 401k to drop your income under the bottom of the tax bracket and you’ll pay taxes in the lower bracket only.

401k Contributions and Advanced Tax Planning

Unlike IRA contributions which can be made until April 15th of the following tax year, 401k contributions have to be during the tax year (before December 31st). 401k contributions also have to be made via salary withholding which means you can’t just write a $10,000 check at the end of the year to bump up your 401k contributions to the right level.

In order to specifically target an income level or total wages, you’ll need some advance tax planning. Calculate the ballpark withholding you think you’ll need at the beginning of the year and notify your employer. Then, over the course of the year monitor your 401k withholding and wages to see if they are tracking to the target you have. Adjust your 401k contributions during the summer and again in October. That means only subtle shifts should be necessary (if at all) in the last couple months of the year.

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What Are Pre-Tax Dollars? originally published at Finance Gourmet

401k Withdrawal for Mortgages

Most 401k plans do not allow current employees to withdraw funds from their current 401k. There are two major exceptions.

Remember that all 401k plans are governed by their own specific rules as specified in their plan document. The features described below are allowed, but not required, by IRS rules. As such, they may not apply to your employer’s 401k plan.

A 401k hardship withdrawal allows a current employee to withdraw money from their 401k account for expenses that are “immediate and heavy.”  Immediate and heavy expenses can include payments necessary to avoid foreclosure or eviction, or even expenses associated with purchasing a home. There is no need for an expense to be “unforeseen” when it comes to hardship withdrawals from a 401k plan.

An in-service withdrawal from a 401k is a provision that allows a current employee to withdraw a portion of their current 401k balance. Typically, an in-service withdrawal is used to rollover funds from a current 401k to an IRA or other qualified retirement plan. However, an in-service withdrawal can be used to finance a mortgage if necessary.

Unfortunately, in neither case are the taxes or early withdrawal penalty on 401k plans waived. That means that you will still owe taxes on all withdrawn amounts. For those under 59 1/2 years old, there will also be a 10 percent tax penalty on withdrawals.

401k Loans

Some 401k plans offer loans from their 401k. Essentially, an employee takes a loan from his 401k and then pays it back to the plan over time. 401k loans typically have to be repaid within 5 years, however, 401k loans used to purchase a primary residence are exempt from this requirement.

Be careful with 401k loans however, There are many downsides to a 401k loan.

Exception for First-Time Home Buyers

One of the trickiest thing about financial planning is that there are often rules that apply to only certain types of investments and accounts. This is doubly true in retirement planning where the rules for 401k accounts, IRA accounts, 457 plans and 403b plans all are very similar, but not the same.

Many people have heard of an exception that allows an early distribution from a retirement account to buy their first home. Unfortunately, this first-time home buyer exception for 401k withdrawals doesn’t exist.

However, an IRA allows an early withdrawal for purposes of a first-time home purchase. This rule offers an exemption from the usual early withdrawal penalty for people under 59 1/2 who are taking money out of a retirement account.

The first-time home buyer exemption for early withdrawals applies to IRA accounts, but NOT to 401k accounts.

Withdrawing Money from 401k for Mortgage

Many people wonder when they can take money out of a 401k to help with a mortgage or to buy a home.

The answer is that you can take money out of a 401k at any time so long as you have separated from service (no longer work at that company).

That does not mean that you can take money out of a 401k tax-free.

All withdrawals from a 401k (except for Roth 401k contributions or other non-deducted deposits) are considered income and are subject to ordinary income taxes. In addition, anyone under 59 1/2 years old taking money out of a 401k will be hit with a 10 percent tax penalty.

Be sure to run the numbers before taking money out of your 401k plan for your mortgage. The taxes may be so high that is isn’t worth it.

You may also want to consider using a Roth IRA as an emergency fund.

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How To Use 401k For Mortgage Purposes originally published at Finance Gourmet

That is why getting an official looking letter in the mail or delivered at work informing you of your “rights” and about an upcoming blackout period can make even savvy investors nervous.

401K Changing Plan Administrators

All 401(k) plans are administered by a third-party. This arrangement protects workers retirement savings by ensuring that the company does not have any access to the money invested by workers in their defined contribution plans like a 401k plan. The third-party is a financial company such as a mutual fund company, insurance company, bank, or brokerage, that takes on the responsibility of accepting deposits, investing money into the proper funds or other investment choices, and keeping track of those investments. And, when the time comes, this third-party is also in charge of completing the withdrawals from your 401(k) and getting the monies to you in the form of a check, band deposit, transfer, or rollover.

This third party is called the plan administrator, because they are responsible for the administration of the plan. The plan administrator does not work for free. Typically, the administrator receives compensation in the form of a cash payment from the company and from each plan participant (worker who invests in the 401k) in the form of extra expenses charged on investments via a higher expense ratio.

Like any other vendor that provides services to the company, they can be replaced by another vendor. This can happen for lots of reasons. The most common reasons a company changes their 401(k) plan administrator are to get lower expenses (usually for both the company and the employees), to get better service, and to better investment choices.

When a 401(k) plan changes its administrator, there are several things that need to happen. Most critical to the employees contributing to the 401(k) plan is that the money currently invested with the old administrator has to be transferred to the new plan administrator. Doing this requires a blackout period.

Why A Blackout Period?

To understand the purpose of the blackout period, it is useful to think about how any financial account, such as a bank account, works.

Unless you deposit cash (actually dollar bills) into the account, the bank must “clear” the funds with wherever the money is coming from. This is just like when you write a check, the money doesn’t disappear immediately from your account, but rather, whoever you wrote the check to, presents the check to your bank for payment. Your bank verifies the check and your account balance and then transfers the money and deducts it from your account.

A similar thing happens in investing. When you sell and investment, the money doesn’t show up instantly. Instead, stock trades “settle” in 3 days. That means that if you sell 100 Shares of XYZ stock on Monday for $5,000 then your brokerage firm will transfer the 100 shares of stock three days later to whoever you sold them to and that person’s brokerage firm will transfer the $5,000 to your brokerage firm on the same day. This is known as “settling.”

However, the money appears in your account instantly and can be re-invested or withdrawn right away. This is because your brokerage firm executed the trade and therefore is certain that it will receive the money from the other firm. But, what if you transferred your account?

The new brokerage firm did not execute your trade, they won’t be the ones receiving the money. So, your account at the new firm will not show your $10,000 cash immediately. (This is typically taken care of automatically via a “residual sweep” where the new broker transfers whatever is left at the old broker a few days later.) This setup works fine on an individual basis, but you can imagine the complexity of doing the same thing for hundreds or thousands of employees.

To avoid any these issues, your 401k plan will impose a blackout period during which time you cannot make any adjustments to how your money is invested. In other words, you can’t buy or sell anything. Since no one can make any trades during this period, when the transfer occurs there won’t be any “unsettled” trades to cause issues. The transfer can happen cleanly and once all of the cash and securities have been received by the new plan administrator, the employee participants can resume buying and selling their investments in their 401(k) account.

What About Enron?

If you paid close attention to the Enron scandal and bankruptcy you may remember that one of the issues was that the Enron retirement plan was in a blackout period while the company was going under and the employees could not move their money out of Enron stock (it probably wouldn’t have helped much if they could have anyway). As a result, 401k regulations were changed to provide for a shorter blackout period. Today, a blackout period is typically only a week or two depending upon the size of the plan.

What Should I Do During Blackout Period?

Usually, you don’t have to do anything when you get a notice that your 401(k) will be in a blackout period. The exception is if you were planning to make changes to your investment allocation within your plan for some other reason. In that case, you will need to decide whether to make the changes before or after the blackout period.

The other exception is if you are retired and withdrawing money from the 401k plan, then you want to make sure that enough money is in cash during the blackout period since you will not be able to sell any existing investments or make a withdrawal. It is especially important to act if you rely on an income distribution from the plan that would normally occur during the blackout period.

For example, if you normally get $3,000 on the 20th of each month and the blackout period will be from the 15th to the 25th, you will NOT get your distribution on the 20th. Therefore, you will need to make arrangements to get your money by the 14th. However, make sure you check with your HR department to find out what will happen to “missed” automatic distributions or you might end up getting paid twice if the company executes missed withdrawals automatically after the blackout period.

If the plan is your only source of income, it makes sense to raise a little extra cash before the blackout period because you will not be able to withdraw money during the blackout period.

Just understanding what the blackout period is should be enough for most workers. If you have plans to do something with your account and the blackout will get in the way, then take action to have it done first. Otherwise, just keep contributing the maximum amount you can to your 401(k) and follow your smart, long-term, diversified investing strategy.

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401(k) Plan Blackout Period originally published at Finance Gourmet

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