By now, many boomers have built up substantial savings in their 401(k) plans. When facing a job change or retirement there are important decisions to be made regarding this nest egg.
Individuals have several options:
Take a lump sum payment
Leave the money where it is
Rollover funds to a new employer’s 401(k)
Rollover funds to a self-directed IRA
Each of these choices has advantages and disadvantages. Be sure to consider all the factors and weigh carefully the pros and cons against your needs.
CHOICE: TAKE YOUR LUMP SUM DISTRIBUTION IN CASH
Immediate cash for expenses or major purchases
Income tax due on part or all of the distribution
20% mandatory withholding
10% income tax penalty if you are under age 59½ (Exceptions may apply: e.g. separation due to death or disability)
Reduced retirement nest egg value
Taking your lump sum distribution in cash may seem attractive. This may provide you with immediate liquidity, perhaps even allowing for major purchases such as a new car, or a second home.
But, there are some major drawbacks to choosing this approach, including owing income tax on the entire taxable distribution amount, plus a 10% penalty if you are under age 59½. Also, payment of taxes (and any applicable penalties) and the spending of some or all of the remainder ultimately reduces your financial security in retirement, and may leave you having to work longer than you planned.
CHOICE: LEAVE THE MONEY WHERE IT IS
Continued tax-deferred growth
Familiarity with plan
The ability to borrow may be retained (where a new plan may restrict)
otentially limited investment options
Possibly limited distribution options at retirement
Adds to complexity of managing investments due to additional account(s).
Potential for beneficiary restrictions that might affect estate planning
Since you're familiar with your current plan, keeping your money where it is may make good sense in certain cases. The most important advantage is that this choice requires no immediate actions while retaining some ability to make choices later.
Note that not all plans provide for all the options you may want. You will need to ask your plan administrator if your 401(k) plan permits loans from accounts held by separated or retired employees and evaluate the choice of investment options as well as the limits on the distribution options at retirement.
Another issue you might want to think about is convenience. Many people like to keep their funds as consolidated as possible. Having a plan at your old company, and then starting one with your new employer, may be quite inconvenient. You or your beneficiaries would receive multiple statements and have to contact multiple sources when you want to change investment options or withdraw funds.
Finally, plan restrictions that may affect estate planning are important issues to discuss with your professional advisor. Depending on your plan, you may be restricted in who you can name as beneficiary.
CHOICE: ROLLOVER FUNDS TO YOUR NEW EMPLOYER'S PLAN
Keeps all funds together – streamlining management of retirement funds
Tax-deferred growth is retained
May have to wait for eligibility
Check with your new employer to see if they offer a 401(k) plan and when you'll be eligible to participate. If there's a waiting period for participation, consider leaving your funds in your old employer's plan until you're eligible under the new plan.
Make sure all rollover checks are written out directly to the new plan administrator, not to you. If the check is written directly to you, it will be treated as a taxable distribution. Your plan administrator will deduct 20% for taxes and you'll have to come up with the 20% difference in order to do a complete rollover and avoid taxes. You'll get the 20% back when you file your income tax return at the end of the year, as long as you rollover 100% of the funds within 60 days, but why let Uncle Sam use your money interest-free?
CHOICE: ROLLOVER FUNDS TO AN IRA
Tax-deferred growth is retained
Expanded investment options
More distribution options at retirement
Possible unfavorable tax treatment if your funds are primarily invested in your employer's stock
When you leave a job, one of your options is to roll over your funds to an IRA or other eligible retirement funding vehicle, which preserves the potential for your savings to grow tax-deferred. IRAs may also allow for greater access, providing for certain penalty-free withdrawals, including qualified education expenses for yourself, a child or grandchild, certain medical expenses or to pay for a first-time home purchase, up to a maximum of $10,000.
Furthermore, an IRA Rollover can provide more flexibility than a qualified retirement plan in planning your estate by permitting you to designate whomever you wish as beneficiary, whether it be a spouse, child, charity, etc.
Finally, an IRA Rollover allows you to invest in a wide array of investment options and products. Greater choice permits broader investment diversification. Consequently, you can be better situated in managing risk
This choice may be an attractive option if you are out of work and need immediate income. Under Internal Revenue Code Section 72(t), you may take early distributions of funds from your IRA Rollover or qualified plan as long as they are part of a series of substantially equal periodic payments, made for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary.
To put it simply, you may be able to access immediate income from your IRA Rollover or qualified plan funds before age 591/2 without paying the additional 10% federal income tax penalty on top of the regular ordinary income tax imposed. These payments must be received at least annually, for the greater of 5 years or until after you reach age 59½. Other IRA Rollover or qualified plan funds may remain invested.
Unfortunately, you cannot pick the exact payment amount you would like to receive (e.g., you cannot request $5,000 a year for life). The amount has to be determined by a formula and the IRS has set specific methods to determine the amount of the substantially equal payments. You may, however, be able to structure multiple IRAs to effectively meet your needs. Ask us how.
Ultimately the choice is yours
Because each company has its own set of rules governing departing and enrolling employees in their 401(k) plans, you will need to check with the respective Plan Administrators regarding specifics.
If you are confused about which choice holds the greatest potential benefit for you, please contact our office or your professional tax advisor. We can work with you to develop a plan that best meets your needs and particular circumstances.
Sources: Tax Facts, National Underwriter Company
Financial Planning Consultants, Inc.
CCH Master Tax Guide
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