Pros and cons of rolling over a pension into an IRA

If you are wondering what to do with your pension plan, check out the pros and cons of rolling over a pension into an IRA.

3 min read

If you are leaving your employer, you need to make the right decision for your pension plan. You can decide to cash out, or rollover the funds to an IRA or a new employer’s retirement plan. Each of these options may have a tax implication, and you may be required to pay income taxes on the distribution, and a 10% penalty tax if you are below 59 ½.

When rolling over a pension plan to an IRA, you must have a qualifying event to initiate a rollover. Usually, you can’t rollover your pension plan if you are still working with the current employer. You must have separated from your employer or the employer is ending its pension plan. A pension plan may be terminated when the company has been closed down, declares bankruptcy, or is merged with another company.

Pros and Cons of Rolling Over a Pension Plan into an IRA

The pros of rolling over a pension plan into an IRA include a wider variety of investment options, tax avoidance, greater control over your retirement savings, and withdrawal flexibility. The cons of rolling over into an IRA include lost creditor protection, no loan options, and penalties on early retirement.

Pros of rolling over a Pension into an IRA

Pro: Variety of investment options

An IRA has a wide variety of investment options compared to a pension plan, which limits participants to a select number of approved investments. An IRA allows you to invest in multiple investments such as mutual funds, index funds, stocks, bonds, etc. You can allocate your portfolio depending on the investments you prefer and your risk profile.

Pro: Avoid paying taxes

If you choose to rollover your pension directly to a traditional IRA, you will not pay taxes or penalties on the distribution. A traditional IRA is a tax-deferred retirement account, and it defers payment of taxes until when you withdraw money. However, this is different for a Roth IRA, which is taxed when you rollover your pension funds into the retirement account. Withdrawals from a Roth account are tax-free.

Pro: Withdrawal flexibility

Generally, pension plans limit how and when a participant can make a withdrawal. When you rollover your pension plan into an IRA, you have greater flexibility if you decide to withdraw funds before retirement. IRAs do not limit the number of times you can withdraw funds, but you will be required to pay income taxes and penalties on the withdrawal amount. Also, there are certain exemptions such as qualifying education expenses, medical expenses, and first-time home purchases that allow participants to make a penalty-free withdrawal from an ITA.

Pro: Greater Control

An IRA gives you greater control over your retirement savings. You can decide where to open an IRA, choose investment options based on your risk profile, and determine the asset allocation in your portfolio. If you switch jobs in the future, you can still retain your IRA account and continue saving for your retirement. This sidesteps key limitations of a pension plan where you are just a participant, and leaving your job means you won’t make further contributions to the retirement plan.

Cons of Rolling Over a Pension into an IRA

Con: No loan option

When you roll over to an IRA, you give up your ability to take loans on your retirement savings. Pension plans may allow participants to borrow or take an advance on their accumulated savings, sometimes up to 50% of their pension contribution. However, this benefit is not available in an IRA. Instead, you may be forced to take an early withdrawal that is subject to income taxes and penalties.

Con: You plan to retire at 55

Pension plans allow participants to take a penalty-free distribution when they retire or leave the company at 55 years. However, by rolling over to an IRA, you will have to wait until you are 59 ½ to take a penalty-free distribution. If you withdraw funds before 59 ½, you will have to pay a 10% penalty for early withdrawals, which could take a huge chunk of your retirement money.

Con: Lost creditor protection

The retirement savings accumulated in a retirement plan are creditor-protected, and creditors cannot seize your funds when enforcing a collection or in bankruptcy situations. However, funds rolled over to an IRA do not receive the same level of protection as funds in employer-sponsored retirement plans. Each state has different rules on the amount of IRA funds that are protected from creditors.

How to Rollover a Pension Plan into an IRA

Before rolling over your pension, you should consider the different rollover options i.e. direct and indirect rollover. With a direct rollover, you will need to set up an IRA account and provide the account details to the plan administrator. The administrator will initiate the pension plan rollover to an IRA without requiring your intervention. This form of IRA rollover does not create a taxable event.

With an indirect rollover, the employer issues a lump-sum distribution via check, and you must deposit the funds into an IRA account within 60 days. Otherwise, deposits after the 60 days have elapsed will trigger a taxable event, and you will be required to report the distribution in your annual tax return, and pay a penalty tax if you are below 59 ½.