Weighing 401(k) Options at Retirement
Photo Credit: Piret Ilver, Unsplash
Key Points
■ Your 401(k) may be your single largest retirement asset.
■ The wrong decision can result in substantial taxes, penalties, and an unnecessary reduction of your hard-earned retirement assets.
■ A qualified tax and financial advisor can help you make smart retirement planning decisions.
So you have decided to retire. You have worked hard for many years, and it is time to relax and enjoy the rewards of your effort. However, before you retire, you should carefully examine your 401(k) retirement plan. It is likely one of your most valuable possessions, and your decisions about it will have long-term implications for you and your family.
When you retire, taking care of your 401(k) may be the most critical issue. The decisions you make regarding the earnings of your 401(k) plan can significantly impact your financial security for the rest of your life. That is why, before doing anything else, you should consult your financial adviser to determine what is best for you.
To assist you in starting a conversation, we have developed a list of choices to explore when deciding what to do with your 401(k) at retirement. Although this is not an exhaustive list, it will get you started in the right direction.
Take Your 401(k) In Cash
The prospect of receiving income from your 401(k) when you retire is appealing. It would help to consider a few things before receiving a check for the whole distribution (or even a portion).
By having the check written out in your name, you may pay up to 25% in federal taxes. When a distribution is paid out directly to you rather than rolled over and deposited into an employer retirement plan or an individual retirement account (IRA), the company automatically withholds 20% of the money for federal taxes. Depending on your state of residence, state taxes may also be deducted.
You will almost certainly have an extra federal tax burden when you file your taxes unless you ask your employer to withhold more than 20% because practically all current income tax brackets exceed 20%. If you are under 55 when you leave work, the IRS usually charges you an extra 10% penalty.
If you accept the distribution in cash and subsequently decide to roll it into an IRA to avoid paying taxes on the distribution, you can still do so. Nevertheless, you must reinvest the assets within 60 days of receiving the distribution. If you wish to make the rollover "whole," you must deposit extra funds to cover the amount of federal (and, if appropriate, state) taxes deducted by your employer. When you submit your income taxes, the amount withheld by your employer will be credited to you.
You should consider whether receiving all or a significant portion of your 401(k) account in cash is a tax-effective method to receive your retirement income. If you still feel this is the best option, we suggest talking with your financial advisor to review this scenario against the other options discussed below.
Roll Your Assets Into An IRA
Rolling over assets to an IRA may provide the most investing freedom of any distribution option in retirement.
A rollover is a transfer of some or all of your plan account to another retirement account, such as a rollover IRA. When you conduct a "direct rollover," the distribution is sent directly to the IRA held by a qualified custodian, and no taxes are withheld. To do so, inquire with your plan administrator about the plan's processes. The plan may issue a check made payable to the IRA's custodian trustee for the amount you intend to roll over and mail it to you for delivery to the new trustee, or the plan may send the check directly to the new trustee. Please keep in mind, however, that the check should only be written out to you if you receive the cash distribution.
Although your final decision will be based on your unique circumstances, certain factors must be considered.
Roth IRA
You can transfer some or all of your assets to a Roth IRA. Amounts withdrawn from a standard 401(k) account are taxable but do not incur a tax penalty. Amounts carried over from a Designated Roth Account are not subject to immediate taxation.
The Roth IRA has no required minimum distributions (RMDs) throughout the owner's lifetime. Furthermore, a Roth IRA's withdrawal is tax-free, provided certain conditions are satisfied.
Traditional IRA
Distributions from your 401(k) plan are exempt from the 10% penalty if you retire after age 55. Still, distributions from a traditional IRA are subject to the 10% early withdrawal penalty until you reach age 59 1/2, so rolling over the entire distribution may not be your best option if you are under 59 1/2 and anticipate needing to take some or all of the money before reaching age 59 1/2. Consider how investment alternatives, services, fees, withdrawal options, mandated minimum distributions, and tax treatment may influence your circumstances and retirement goals. Please remember that transferring retirement assets into an IRA account may result in higher costs since the underlying funds may be subject to sales loads, increased management fees, 12b-1 fees, and IRA account expenses such as custodian fees. Consult your financial advisor for help assessing if a rollover to an IRA is right for you.
Leave The Assets Where They Are
There will be no current tax bill if you leave your account alone or roll it into an IRA. In this sense, both alternatives are equivalent. Yet, there may be significant variances in distribution and investment opportunities.
Your employer's plan may have other distribution alternatives besides a lump-sum payout. You can choose to receive your account balance in the form of a series of recurring installments. If this is the case, you will only be taxed on the amounts you receive, while your account balance can grow tax-free. You can reduce your tax obligation by taking what you need each year. If the distribution alternatives in your plan meet your needs, keeping them in the plan is a good option. An IRA rollover may be helpful if it does not provide the desired flexibility.
An employment plan's investment options are often more limited than an IRA's. In certain circumstances, the investments used to prepare for retirement differ from those used after retirement.
Your Age Matters
If you leave your job after January 1 of the year you turn 55, payouts from your former employer's eligible retirement plan are not subject to the early withdrawal penalty. This penalty exemption is not accessible in an IRA. Before rolling your plan into an IRA, consult your tax advisor if you are between 55 and 59 1/2.
Think it through
Whatever your choice, you must think it through and make the best decision based on your financial requirements, goals, and risk tolerance. After all, you have been saving for the type of retirement that most people only dream about—a retirement that might be jeopardized if you make an incorrect decision. Remember to discuss these options with your financial advisor.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
Portions of this article were sourced from the work of MFS Heritage Planning. Neither MFS nor any of its subsidiaries are affiliated with Optima Capital Management.
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