By Greg Storen
A client recently walked into my office and placed his 401(k) statement on my desk. He looked at me, pointed to the document and asked, "Can I bombproof my 401(k)?" I looked at him and told him he was in luck.
He has a few options to consider when it comes to managing risk. I offered four: He could simply cash out his plan dollars, make allocation changes in the plan, transfer the plan dollars to a plan with a different employer or he could simply transfer the dollars to a rollover individual retirement arrangement (IRA) via an In-Service Distribution.
Many people diligently focus their energy on accumulating assets into their Employee Retirement Income Security Act (ERISA) 401(k) or 403(b) employer plans. But, they don't take the time to understand all the associated rules and options those plans may afford to them as they approach retirement age. Here are the advantages and disadvantages to your options
Cash Out the Plan
The client will be required to withhold 20% federal income tax on the pre-tax dollars being distributed.
The dollars from the plan will now be post-tax money and can be invested any way the client chooses.
The employee will pay income tax on 100% of the pre-tax dollars coming out of the plan.
Any distributions taken prior to age 59½ (age 55 if separated from service) may be subject to a 10% federal tax penalty.
Leave the Money in the Plan
It is easy. They won't need to do anything with the custodian.
Make changes to the allocations to reallocate the risk to a level appropriate for them.
The fees may prove to be lower in the existing retirement plan. Under ERISA, code sections 408(b) (2) and 404(a) (5) require all plan participants receive a full disclosure of fees related to their company plan, including indirect and direct compensation and services. This information helps employees make the most informed decisions.
There may have limited investment options.
The client may not have any assistance or guidance from the plan's custodian when making allocation changes to their retirement account.
There are limited withdrawal options.
Spouses are required to be the beneficiary unless the spouse signs to recuse himself/herself.
In most cases, 401(k) funds qualify for creditor protection under the federal law known as ERISA.
There are no required minimum distributions or RMDs from the plan if the client remains employed when they reach the age at which they are required to take RMDs.
Employees can borrow from the plan dollars if the plan allows.
Transfer the Plan Dollars to a Different Employer's Plan if Employed
There may be more or better options to choose from with the additional employer's plan.
The plan may or may not accept the other plan's dollars.
This may be an opportunity to combine plan dollars into one plan.
A client would have have total control and ownership of the investment. They can choose the investment strategy and the custodian without any restrictions, including additional withdrawal options.
They can use the In-Service Distribution to enjoy the best of both worlds by leaving some dollars in the employer plan and also transferring some to their IRA.
Name anyone as a beneficiary with no spousal approval required. The IRA beneficiary can be updated and changed as frequently as they like, but they must remember to always name a primary and a contingent beneficiary.
There is no federal withholding requirement. The owner determines the federal and state withholding amounts needed, if any.
IRA owners are able to shop and compare competitive fee pricing, which can result in savings compared to employer plan fees. Clients often say, "Oh, there are no fees in my 401(k)," but we know this isn't true.
IRA owners maintain bankruptcy protection for their IRAs. However, like the ERISA plan, the amount of IRA dollars protected in bankruptcy is unlimited if dollars are rolled over to an IRA. Non-bankruptcy creditor protection of the IRA varies from state to state; some states have unlimited creditor protection while others are limited.
A rollover IRA is ready to house any additional plan dollars contributed prior to retirement, making the transition that much easier.
Transferring plan assets to an IRA can disqualify an opportunity to benefit from Net Unrealized Appreciation (NUA), an option to tax gains from highly appreciated company stock at the more favorable long-term capital gains tax levels as opposed to ordinary income tax. Company stock is transferred from the company plan to a non-qualified account. Ordinary income tax is paid on the basis of the company stock, and the gain of this stock will be taxed at long-term capital gains rates when sold in the future. The ability to pay tax at the long-term rate on a portion of the plan dollars benefits the account owner.
Some qualified plans allow one to contribute after-tax dollars. They need to be sure these monies are distributed to a Roth IRA or non-qualified account, as they don't want to co-mingle after-tax dollars with pre-tax dollars. If this happens, a CPA will be required to complete IRS tax form 8606 every year thereafter on federal taxes to inform the IRS what amount of after-tax money is in a pre-tax IRA. It's much easier to segregate the two balances and have 100% access to after-tax dollars.
People cannot borrow money from a rollover IRA or contributory IRA.
It Can Be a Tough Decision
My client had a tough decision to make. It became clear to him he needed to complete his due diligence in regard to reviewing his plan rules and documents, be sure he understood all options available, consult with his CPA and/or adviser and be sure the decision he made was right for him.
As we all know, the needs of each individual are unique. Understanding a company's ERISA plan, the options available and when they can be used can make a real difference in personal retirement planning.
About the author: Greg A. Storen received his MBA from Butler University and is a member of Ed Slott's Master Elite IRA Advisor Group. Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Brass Tax Wealth Management, a registered investment adviser. Brass Tax Wealth Management and Storen Financial Advisory Group and LPL Financial are not affiliated with Ed Slott. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.