Q: I’m about to retire next month and am looking at my options for what I can do with my 401k money.
I’m a little confused about my distribution choices. Can you please offer some guidance?
A: First, please let me congratulate you on your pending retirement! Many people are not sure what choices they have for their retirement savings when leaving an employer. And making a wrong choice can have severe tax consequences. Here’s what you need to know.
Changing jobs or retiring? Don’t forget your retirement savings!
If you’re like many Americans, you probably intend to rely on your employer-sponsored retirement plan savings for a significant portion of your retirement income. So when it comes time to make important decisions, such as what to do with the money in your plan when you change jobs or retire, you should be fully aware of your options.
‘Distribution’ defined
You may have read about or heard benefits administrators at your workplace refer to retirement-plan “distributions.” This is just a fancy term used to describe a payout of the money that has accumulated in your retirement-savings account. Distributions may include amounts you have contributed and the “vested” portion of any amounts your employer has contributed, in addition to any earnings on those contributions. Retirement-plan participants have several options for managing the money in their account when they change jobs or retire. Depending on your age and goals, each option may carry different tax consequences and investment opportunities. That’s why it is important to think through each option carefully before making any decisions.
Typical distribution options
Keep money in a former employer’s plan. Depending on the plan’s rules, you may be able to leave your savings in your former employer’s retirement plan whether you are changing jobs or retiring. Retirees — particularly those who plan to work in some capacity or who can draw on other sources of retirement income — may want to leave the money where it is and continue to reap the benefits of tax deferral. In addition, if you plan to start your own business when you leave the company, keeping your retirement money in your former employer’s plan may help protect your retirement assets from creditors should your new venture run into unforeseeable trouble.
While you will no longer be able to contribute to the plan, you will still have control over how your account is invested. If you are happy with the investment options available through your former employer’s plan, this may be a choice worth considering. Of course, keep in mind that minimum distributions must begin after you reach age 70-and-a-half.1
Make a “direct rollover” to another retirement account. You can move your money into another qualified retirement account, such as an individual retirement account or, if you’re changing jobs, your new employer’s retirement-savings plan. With a “direct rollover,” the money goes directly from your former employer’s retirement plan to the IRA or new plan, and you never touch your money. With this method, you continue to defer taxes on the full amount of your plan savings.
If you are about to retire, are between jobs or simply prefer the flexibility and wider assortment of investment choices offered through an IRA, then an IRA rollover may be a better option.
Take a cash distribution. You can choose to have your money paid to you in one lump sum when you retire or change jobs. This action is considered a cash distribution from your former employer’s retirement account. The cash payment is subject to a mandatory tax withholding of 20 percent and possibly a 10-percent penalty if you were under age 55 at the time you left the company.2
Lump-sum distributions: Not always what they appear to be
Amount of distribution: $25,000 Amount withheld for federal income taxes: $5,000 (Potential) 10-percent penalty: $2,500 Additional tax obligation (based on 25-percent tax bracket): $1,250 Net payout: $16,250
This hypothetical example has been simplified for illustrative purposes. It is not representative of any specific situation. Your results may vary.
Consider an “indirect rollover.” You can avoid paying taxes and any penalties on a cash distribution if you redeposit your retirement plan money within 60 days into an IRA or your new employer’s qualified plan. With this strategy, called an indirect rollover, you’ll still have to pay the 20-percent withholding tax out of your own pocket, but the tax will be credited back to you when you file your regular income tax, and any excess amount will be refunded. If you owe more than 20 percent, you’ll need to come up with the additional payment when you file your tax return.
Seek guidance
It is important to remember that these are complicated choices with lasting implications for your retirement years. Before making any decisions, consider talking to a tax and/or financial advisor who has experience helping people make prudent choices for funding their retirement years.
1Distributions will be taxed at then-current rates. 2Additional taxes may be due, depending upon an individual’s tax bracket.
ALERT: With all of the exciting recent news coming from Washington, D.C., about same-sex marriage recognition for certain federal-benefit programs, I’m sure many of you have questions. Please feel free to contact me if I can offer any guidance on how these latest developments may impact you and your partner. And please look for upcoming OutMoney columns, which will address some of these issues as they continue to develop.
Jeremy Gussick is a Financial Advisor with LPL Financial, the nation’s largest independent broker-dealer.* Jeremy specializes in the financial planning needs of the LGBT community and was recently named a 2013 FIVE STAR Wealth Manager by Philadelphia Magazine.** He is active with several LGBT organizations in the Philadelphia region, including the Delaware Valley Legacy Fund, the Greater Philadelphia Professional Network and the Independence Business Alliance. OutMoney appears monthly. If you have a question for Jeremy, you can contact him via email at [email protected]. LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
*As reported by Financial Planning magazine, 1996-2013, based on total revenues. **The Five Star Wealth manager is an award based on client satisfaction. Respondents evaluate criteria such as customer service, expertise, value for fee charge and overall satisfaction. The overall score is based on an average of all respondents and may not be representative of any one client’s experience.
This article was prepared with the assistance of S&P Capital IQ Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor, or Jeremy, if you have any questions.
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