TRICKS OF THE TRADE
“401(K) ROLLOVERS AND PENSION DISTRIBUTIONS”
Prepared by Michael Menninger, CFP
Most people working today have a retirement plan through their employer, such as a 401(k) or a 403(b). The 401(k) and 403(b) plans are virtually identical, except that 403(b) plans are offered by non-profit organizations. Both plans are identified as Defined Contribution (DC) plans, because the employee defines what they will contribute. Traditional pension plans are identified as Defined Benefit (DB) plans, because there is a formula that defines the monthly benefit you will receive upon retirement.
In most cases, employees are restricted from withdrawing assets from these retirement plans, except if they are terminated from employment (e.g. – layoffs, switching jobs, or retirement). In few cases, employers allow for in-service distributions, which would allow the employee to take a distribution from the plan. However, these are typically restricted to attaining age 65, or hardship distributions (outside the scope of this article).
In the case of pension plans, most private companies have moved away from these plans because people are living longer and the future liabilities to the company are not well defined. Thus, these pension plans seem to be limited to governmental organizations and very few large corporations. Interestingly, many of those same corporations formerly had pension plans, closed them, and offered their participants the opportunity to take a lump sum distribution in lieu of the monthly pension payment. This will be discussed later, but the lump sum distributions generally follow the same rules as distributions from a DC plan, such as a 401(k) or 403(b).
401(k) ROLLOVER OPTIONS
When taking a distribution from a retirement plan, the individual generally has four choices of what they can do with the money.
- Take as Cash – This is when the participant takes the money as a distribution to themselves. This may be very tempting, but it comes with (often unexpected) consequences, in that the entire balance is subject to income tax, and if the participant is under age 59.5, they may be subject to an additional 10% tax penalty. As per IRS rules, the company is required to withhold 20% for Federal tax, so the actual amount of distribution will be less than the account value. In the event that the participant didn’t intend to withdraw money in this manner, they have 60 days (with certain restrictions) to put that money back into an eligible retirement plan, which is referred to as an indirect rollover. Just remember that the participant will need to come up with the extra 20% that was withheld for taxes, or that amount will be subject to tax, because they didn’t put all the money back into a retirement plan.
- Leave Money in Plan – The participant can also leave the money in the existing plan. By doing so, there are no tax ramifications. The disadvantage of this option is that the participant is limited to those investment options in the plan. Plus, a loan is not an option because the individual is no longer an active participant in the plan.
- Rollover Money to New Plan – If the participant has a new / current employer with a retirement plan, and that retirement plan accepts rollovers, then the participant can select this option. The advantage is consolidating assets into one account, and it also allows the participant to have additional assets that may be borrowed against, if the plan allows it.
- Rollover to Traditional IRA – This is the most flexible alternative available to the participant. This allows the individual to have a much broader array of investment choices and they can seek the guidance from a financial advisor. Plus, the IRA can be converted to a Roth IRA (most retirement plans do not allow for this option), which may provide long-term tax advantages to the individual. Further, this does not preclude the individual from transferring that money into his/her current retirement plan at a later date, so long as that plan allows for incoming transfers.
Pension Plan Lump Sum Distributions
If an individual has a pension plan that allows for a lump sum distribution, there are a lot of advantages to doing so. First, if the individual is in poor health and they die after collecting a monthly pension payment, some or all of that pension may be lost. The same can be said if the individual dies, and then his / her beneficiary subsequently dies, then the money is lost for good. Lump sum distributions allow for the individual to take a lump sum of money, and can apply the four options listed above for that money.
Lump sum values are actuarially calculated, which means they start with the anticipated monthly benefit and age, estimate the number of anticipated payments based on your age (and sometimes gender), and then provide a dollar amount that is based on your current age and the assumed interest rate used in growth calculations. Since all of those factors are constant except the assumed interest rate, then the amount of the lump sum is impacted by current interest rates. When interest rates are low, then the lump sum amount is greater than when interest rates are high. So, because interest rates are at virtually all-time lows right now, then the subsequent lump sum distribution amounts will likely never be higher than they are now.
As with most financial decisions, the best option for rolling over an old 401(k) or a pension is “it depends”. We suggest you contact your financial advisor to help you decide which option is best for you, or feel free to call us if you have any questions.