Ready For Retirement

The Tax-Smart Way to Consolidate Your Retirement Accounts

September 12, 2023 James Conole, CFP®
Ready For Retirement
The Tax-Smart Way to Consolidate Your Retirement Accounts
Show Notes Transcript Chapter Markers

By the time you get to retirement, it is not uncommon to have many different accounts at multiple different institutions. You may be wondering, "How do I begin the process of consolidating everything without paying a bunch in taxes or penalties?"

In this episode, James covers three types of taxes you're likely to encounter when consolidating: ordinary income, capital gain, and early withdrawal penalties. He also explains strategies to sidestep these taxes and penalties and how to decode your current allocation to pinpoint your income needs.

Questions answered:
What is a good strategy for consolidation?
How do you ensure you won't get penalized for consolidating?

Timestamps:
0:00 Intro
1:55 The situation
5:18 Capital gains
8:46 Income taxes
14:03 401k plans
17:31 Allocation 
21:21 Alternatively
23:45 Outro

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Speaker 1:

But time you get to retirement, it is not uncommon to have many different accounts at multiple different institutions. And as you're going into retirement and you're trying to simplify things, you likely are asking yourself how do I begin the process of consolidating everything but do so without paying a bunch in taxes or penalties? Well, that's exactly what we're going to go over on today's episode of Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode is going to be a response to a listener's question, and this listener's name is Tim. Tim, thank you for submitting a question, and Tim says the following. He says Hi and great podcast, thank you. I am 60 years old and I want to retire in the next two years. I have investments in multiple institutions. I would love to simplify and consolidate. However, it seems I will get hammered with a large tax bill if I solve from one to bring the funds to another. What is a good strategy for consolidation? This includes 401Ks, roth IRAs and brokerage accounts. Thank you, tim. And Tim, I'm real glad you asked this question, because this is one of those things that I take for granted, having helped so many different people do this. There is a right way to do it, and when you do it the right way, it's pretty simple and you avoid taxes and penalties. But you do need to know what things you need to look out for so that you can ultimately avoid them. And then, thank you for that question. I think this will be a good episode. Before we do so, before we jump into it, I do want to highlight the review of the week. Now, this review is also from someone named Tim. So, tim, if this is you as well, thank you very much, both for the question and for the review. And the review is as follows it's a five star review and it says Love the show. I'm closing on an retirement age, so I appreciate your sound advice and information. Thank you, tim. And then the title is great and informative. So both Tim's maybe one of the same Tim I've said Tim already, maybe a hundred times on this podcast already appreciate the feedback there and the question. So, going back to the question, the topic for today, here's the situation that Tim finds himself in. He is six years old. He's planning to retire in the next couple of years and he has investments at multiple different institutions. This is pretty normal because during a person's career they may have multiple jobs, which means multiple 401ks. Now some of these 401ks may have been rolled over to an IRA. Some may have stayed with the institution where they were held when the person was working there. Maybe this person opened various Roth IRAs or brokerage accounts over the years. Maybe they invested some money with a brother-in-law or a neighbor at some point. Maybe they opened a side account to buy some stocks they liked at some point along the way. Maybe they opened another account to invest proceeds from a bonus or stock comp that vested over time. So when you look at it, it's very normal to have many different accounts at sometimes many different institutions. Now some people stay very organized and as they go from one job to another, they either roll over their old 401k into their new company's 401k or they roll over their old 401k into an IRA where they have more control and flexibility with those funds. So you do see a mix of both. But my thing that I like to tell people is by the time that you actually get to retirement, you don't want to have too many different accounts. Ideally, you have a traditional IRA or Roth IRA and some type of an after-tax account or brokerage account. Now, if you have different goals within that brokerage account for example, maybe one is for retirement income and another is to purchase a second home and another is kind of a legacy account and just making stuff up but if you have different goals, then yes, there should be different accounts for those goals, because you should have different investment strategies within them. But in general, you probably don't need much more than three different account types, and that's simply because one should be pre-tax, one should be Roth and one should be brokerage by the time you get to retirement. And this is because if you have 12 different accounts, 15 different accounts, 20 different accounts, good luck trying to create a withdrawal strategy from that. Which account are you going to draw down first? How are you going to invest in each account so that your overall portfolio that encompasses everything is allocated the right way and you're not too concentrated in some areas and underexposed in others? So, to get the right income strategy, to get the right investment strategy, even to get the right tax strategy, it's typically helpful to try to simplify and consolidate things as opposed to keeping things all spread out. But here's the problem that Tim brings up. He's approaching retirement and he's realizing this. He's either thinking this is way too much energy to create a strategy around this, or it's just way too much energy to try to track everything. How do I start the process of simplifying but, at the same time, I don't want to incur a large tax bill to do so? If I'm moving funds from one institution to another, if I start the process of consolidation, how can I ensure I'm not getting penalized essentially for doing so? So here's what we want to start with. We want to start by understanding the various tax implications of consolidating retirement investments. There's three main types of taxes that you need to look out for when you do this. Number one is ordinary income taxes, number two is capital gain taxes and number three is early withdrawal penalties. Now, thankfully, there's a pretty simple way to avoid most, if not all, of these as you begin the process of consolidation, but you do need to understand your options and you do need to understand the most effective way to do this. So let's start with capital gains. Capital gains is, I believe, what Tim was referring to specifically in his question. Capital gain taxes are taxes that are paid on the profits from the sale of an investment. So if you buy a stock and it increases in value and you sell that stock and that stock is not protected by being held inside of an IRA or Roth IRA or something like it, you pay taxes on that. For example, let's assume that you bought a Vanguard S&P 500 ETF a decade ago and now you have $50,000 worth of gains. Maybe you bought it for $40,000 and now it's worth $90,000. If you sell this fund and again, I'm assuming this fund is held in a brokerage account and not protected by any type of retirement account you have a $50,000 gain that you then owe taxes on. So, as Tim's looking to consolidate his investments, he's saying look, I have these investments. I have no idea what his actual investments are, his specific holdings, but, to use this example, he's saying I don't want to have to sell this fund and then pay taxes on a $50,000 gain. So how do you avoid this? Well, the first thing to note is most institutions allow you to do what's called an in-kind transfer of assets. For example, let's go back to the S&P 500 ETF that I talked about. Let's assume that Tim owns that exact fund and he holds it at Fidelity, but he's decided that Charles Schwab is the institution where he's going to consolidate his assets for retirement purposes. Well, what he could do is, instead of going to Fidelity and saying, hey, please sell my fund, realize all these gains I should say that I now have to pay taxes on. He's saying he could simply tell Fidelity, via Charles Schwab and their transfer department please move the money I have in this fund to Charles Schwab and then all the shares that he owns from Fidelity, all the cost basis information, so the information essentially, that tells you what did you pay for this? So that you can calculate any future taxes owed on a capital gain. All that transfers over in kind to Charles Schwab or whatever institution he's transferring to. So you could have investments that have hundreds of thousands of dollars in gains or more. It doesn't matter how large the gains are. An in kind transfer doesn't actually force any of those gains to be realized. Now you do need to confirm with the institution, both where the assets are held as well as the institution where you're going to be holding your assets going forward, that they do allow for in kind transfers. The major institutions do, most institutions do, but you don't want to be caught off guard If, for whatever reason, it's not Fidelity where Tim holds these investments, but it's some other institution, maybe a much smaller one, and they say, hey, we can't transfer in kind, but we can issue a check and whatever your proceeds are, we'll send that to your new institution. If they are having to sell the fund, that sale is what's triggering the capital gain. So confirm with your institutions before doing this. But the major providers, and a majority of the providers, do allow for what's called an in kind transfer, which means whatever you held to the old institution simply moves in kind to the new institution, where essentially no changes are made other than the institution that's holding the money. So that's a way around capital gains taxes. Do an in kind transfer as you're consolidating your assets, so nothing's actually sold, and you begin the process of organizing and consolidating there. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment tax, legal or other financial advice. It is for informational purposes only. The next consideration is ordinary income taxes and early withdrawal penalties. I'm going to lump these together because they're often incurred at the same time. Ordinary income taxes are any taxes you would pay if you pulled money out of a pre-tax account. Say, for example, you worked at a company for three years and over those three years, between your contributions and any employer matching contributions, you saved up $50,000 in that 401k. Well, let's say you go to your old company or your old company's 401k provider and say, hey, I want to consolidate that money. And you go to them and you don't do things right. You end up asking them to distribute that $50,000 to you. So they issue you a check. So in this case, maybe they pay Tim $50,000 and Tim all the while thinks, okay, well, I'm going to take that $50,000 and reinvest it in my other accounts. Well, if it's not a direct rollover, or if he's not working within what's called a 60-day rollover window, or even if it is a direct distribution, he turns around and reinvests it into his IRA. He's going to end up paying taxes on all of that. And to make matters worse, if he's under the age of 59 and a half, not only is he going to pay taxes, but he's also going to pay a 10% early withdrawal penalty. If you're under the age of 59 and a half and take a premature distribution from any pre-tax retirement account, you pay a 10% penalty. There is a special rule that lowers that age. That essentially says if you retire from the company where that 401k is held in the year that you turn 55 or later, then that age is dropped to 55. So you have a little bit more leeway in terms of avoiding that early distribution penalty, but that is something to be very mindful of. So how do you avoid that? Well, again, it's fairly simple. You just need to know, or you just need to understand, when you're processing that rollover or that consolidation, what are the specific instructions you're giving to the old provider to make sure the transfer is done correctly. So here's what you typically want to do to make sure that is done correctly, and there's two types of transfers here. If you are moved, you are moving, say, an old 401k into a traditional IRA. That's considered a direct rollover. So the 401k provider is rolling assets out of the company sponsored 401k plan and into an individual retirement account that you now control. That's different than if you have an existing individual retirement account IRA or an existing Roth IRA and you simply want to move that to a new traditional IRA or a new Roth IRA. So if you're doing something called a trustee to trustee transfer, that's the same as what we talked about in the last example of your simply moving assets in kind from one provider to another and even with an IRA, even if you're not transferring in kind, but as long as it's going from one IRA provider to another, even if investments do have to be sold in that process, it's not going to cause any taxes to be incurred on your behalf, because all that's happening within the IRA and any gains or dividends or interest inside of an IRA, because of the tax protections the IRAs offer, isn't actually taxed. So if you're simply doing a trustee to trustee transfer, then you're not going to have to pay any taxes. The big difference here, though, between transferring an IRA or Roth IRA from one institution to another institution and transferring a brokerage account, so an after tax or non retirement account from one institution to another institution is in the brokerage account example. If you have to sell a fund to initiate the transfer, you do incur taxes on that. So, tim, to go back to your question, hopefully you're at an existing institution where any gains that you have can simply transfer in kind to your new institution. But there are cases where that can't be done. For example and I'm not picking on Fidelity here but Fidelity has an investment platform and they have a certain share class of funds. Now that share class you can own it at Fidelity, but if you ever leave Fidelity, those funds can't go with you. You would have to sell them and then that cash would have to be transferred elsewhere. So if these are a share class of funds that you hold in, say, a traditional IRA that you're transferring to, let's say, a traditional IRA at Charles Schwab, if you have to sell those funds, it's not a huge deal. You simply transfer them, cash moves over to Charles Schwab and then you can reinvest it as you see fit. Worst case scenario there's a funds are out of the market for a couple of few days, so maybe that's not ideal, but it's not the end of the world there. Versus, if you have a brokerage account at Fidelity or some other institution where you're owning a proprietary share class that actually can't move to another institution, you have to look out for that, because if you start building up serious gains in that type of a fund and that fund can only be owned at the institution where you hold it. If you ever decide in the future to make a change, that might cause some problems because you won't be able to transfer those funds in kind. You'd have to sell them first, which triggers a tax bill if this isn't in an IRA or Roth IRA, and then the proceeds in cash could transfer out. So just one thing to be mindful of there. But if you're doing this in an IRA, then that's not a consideration. That's not a concern that you have to look out for, because even if you do have to sell the funds, they could still transfer over and no tax liability would be incurred. Then there's 401K plans. So if you have been working for a company or several companies and a lot of your portfolios and your 401K, you want to make sure that you're electing the right rollover option when you take that 401K, so it doesn't trigger a huge tax bill. Here's the thing with 401Ks. This is maybe one of the most frustrating things about the financial industry is so many things on the back end are still so antiquated. A perfect example of that is 401K providers not always, but almost always. When you go to rollover your 401K, if you're moving it to a different institution, they will still issue a physical check. So I'll go back to my example. Maybe you have a 401K at Fidelity, or maybe you have a 401K at Vanguard, and Tim is trying to consolidate his assets at Charles Schwab for retirement. Well, if he goes to Fidelity or if he goes to Schwab, you would wish that they could just simply take the balance in his 401K and transfer that electronically into his IRA so he wouldn't have to incur any taxes. Number one, but also so that a large check wouldn't have to be floating around. Unfortunately, many 401Ks almost all 401K providers still issue physical checks. It's ridiculous that that's still the case at this point in time, but you'll come to find that many institutions are not keen on making it too easy for you to move your money away from them, and this is just one example of how that plays out. A couple points to add on to that, though, because I've seen people and clients included that get a little concerned during this process because, let's say that your old 401K provider, you, request a rollover and you say, okay, no, it's going to be a check, but that check will be made payable to my IRA and it will just get direct deposited and then I'll have it invested for whatever my needs are. That's the case with some providers, but many providers will issue the check to your home address and so a lot of people they panic and they say, oh my gosh, I don't want the check to my home address. Doesn't that mean I'll pay taxes? Not necessarily, assuming you get that check reinvested. You do have a window and if you get that check reinvested you're not going to pay any taxes on it, especially because the way you should have that check paid is to your new institution. So if we use Tim as an example again, let's assume Tim has his 401K at Fidelity today and he wants to start process or start the process of consolidating everything at Charles Schwab If he goes to Fidelity, fidelity is one of those companies where all the checks that they issue actually get mailed to your home address instead of to the new institution where you ultimately want to have it invested. What Fidelity would do is they would ask Tim a series of questions and if he says this is a direct rollover and I want this money to go to my IRA at Charles Schwab, they would make the check payable to Charles Schwab, but they would still mail it to Tim's home address. So from that point, tim would be responsible for having it deposited into his IRA. Sometimes, though, that gets people concerned because they're thinking doesn't that mean it's a taxable event if I receive the check? Yes, if the check is payable to you, because then it's technically just a distribution or direct distribution to you, but because the check is paid to the new institution, which is how you should have it. If your goal is ultimately to have the money direct deposit it to the new institution, then, because the check is payable to them, it's not a taxable event to you, assuming you turn around and reinvest that into your IRA. So that's the first part of Tim's question. It's a fairly simple process. You can, in most cases, start the process of consolidating assets and transferring assets, and it wouldn't cost you anything in taxes or penalties to do so, if it's done correctly. The second consideration Tim didn't really allude to this, but this is the next follow-up question is how do you then get the right allocation? So, organization and consolidation, that's step one, and from there now it becomes much easier to see. Okay, all my assets are in one place, all my investments are in one place. Now I can start to see what my actual allocation is, because previously, when I had eight different accounts, 12 different accounts, 15 different accounts, it's pretty difficult to actually understand what is my investment mix. Sure, I can tell you what funds I'm invested in over there and what funds I'm invested in over here, but until everything's really consolidated sometimes it's difficult to tell, even at a high level. What percentage do I have in stocks and bonds and cash? And then, at a more detailed level, what percentage of my stocks are large companies or small companies or domestic companies or national companies? Of my bonds, what are short-term bonds, long-term bonds, government bonds, corporate bonds? Once you start the process of getting things consolidated, the next step is to start understanding where am I today in terms of my current allocation and what's my actual target allocation. So the allocation is going to be most suitable for my retirement income needs. Now I'm not going to do an in-depth analysis of what should your retirement portfolio be based on your situation there's other podcasts I've done that, outline that but there are a few quick, high-level ways to think about this. Number one if all of your assets earn an IRA or Roth IRA, then you can simply shift from your current mix to your desired mix, because everything's protected by being in an IRA or Roth IRA, there's no tax impact for doing so. So as soon as you've consolidated and you've identified the areas where maybe you're too concentrated and you've identified the areas where you're underexposed, you can simply make the switch and not have to worry about taxes or penalties to do so. Or if you're in a situation where your assets are fully or partially in a brokerage account, you have to think differently about that. Option number one is, once everything's been consolidated and you see how you're currently invested, in some cases it just makes sense to take the tax hit. If you're way too over-concentrated in a specific area and there's really not an elegant way to unwind out of that but if you stay concentrated, you run the risk of losing a pretty significant portion of your portfolio it might just make sense to take the tax hit. You're going to pay taxes at some point and too often people make decisions with their portfolio solely based upon the tax impact of those decisions. So yes, you want to be smart and yes, you want to avoid taxes wherever possible, but in some cases taking the tax hit is a lesser evil than the potential downside of losing a disproportionate amount of your portfolio because you're too concentrated. A bad market environment comes, and then, instead of paying 15% in taxes, or 20% in taxes, you end up losing 40% to 50% or more of your portfolio because you were allocated the wrong way. A lot of times, though, there's a more elegant way to do this. So let's take a look at an example. Maybe you have $400,000 in a brokerage account, so a non-retirement account, and it's all on an S&P large cap fund. Then let's assume you have $600,000 in a traditional IRA and it's invested in that very same exact fund, the S&P 500 fund. What you realized is you've got a million bucks and 100% of it is invested in the S&P 500, but when you start to look at your target allocation for your retirement goals, you've determined you only want 40% in the S&P 500 and the other 60% diversified across global stocks and bonds. Then, on top of that, when you start looking at needing to make some changes, you realize the $400,000 that you have in your brokerage account of that $400,000, $100,000 is what you put in. The other $300,000 has been growth over the past several years and decades. Well, if you sell that, all that wants to rebalance, you're going to be paying a pretty heavy tax bill. So here's an alternative If you want 40% in the S&P 500, that represents $400,000. In this situation, could you ask yourself, does it make sense to keep the $400,000 already in the brokerage account, fully invested in the S&P 500, and then take the $600,000 in your IRA and allocate that differently to small companies, international companies, bonds, so on and so forth? So the accounts by themselves are then fully unbalanced. Neither of them is diversified. When you look at both the brokerage account and the IRA, but the overall portfolio comes out to be the right mix for you. You do have to be very careful of what's called asset location needs. So what is the right mix to have in your brokerage account versus what is the right mix to have in your retirement accounts? And, like I said before, taxes should be a consideration, but taxes should not be the driving force behind how you allocate your portfolio. But this is one way to think about it. Just think through this and make sure that that allocation makes sense based upon your specific withdrawals that you'll be taken from your portfolio. And then a final consideration I'd say is, if you consolidate everything at one institution, you realize, you know what my current mix is off a little bit, but it's not too far off from where I actually want assets to be, and I do have some pretty significant tax liabilities in this account. If I were to do a full rebalance right now. Another consideration is if you're fairly close to where you want to be, then maybe you consider using dividends, interest and other cash flows to start building towards your desired allocation. So instead of just selling everything, paying taxes and then positioning assets as they need to be, can you instead take interest payments, dividend payments, new contributions to your portfolio and start building towards your desired allocation, as opposed to doing a full rebalance all at once? So this, of course, just depends upon how you're currently invested. After you consolidate, this depends upon what your target investment portfolio or profile needs to look like, but those are a few options that you have, so I hope that's helpful. I know that's a pretty simple and straightforward concept but, believe it or not, I have seen people who've come to us and they ended up paying thousands, tens of thousands of dollars in taxes, even because they made the wrong decision or they did this in the wrong way. So making sure that you get the consolidation process downright is an important part of a well-designed retirement plan. So that is it for today's episode. Thank you, tim, for that question and maybe even for that review, or maybe thank you other Tim if it's not the same person, but please make sure you've left a review. If you're enjoying this content, please make sure to check us out on YouTube for more great material outside of just the weekly podcast, and I will see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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