401(k) Planning

Participants in an employer-sponsored retirement plan are subject to IRS regulations, as well as to the rules of their former employer’s plan documents, which can be more restrictive than those of an IRA. For example, a plan may not allow partial distributions, or if it does, it may limit them to once a quarter or once a year.

It also may be more time-consuming to withdraw money, since a plan may require additional paperwork and signatures from the plan participant, his or her spouse, and possibly the plan administrator.

By contrast, IRAs, in most cases, allow distributions at any time, for any dollar amount, and without any additional authorization. However, it is important to remember that, in addition to income taxes, withdrawals prior to age 59½ may be subject to a 10% IRS penalty tax.

An individual who has money in a former employer’s retirement plan should check the plan documents to see what distribution options are available. Some employer-sponsored retirement plans offer only one lump-sum distribution from the account. If any assets are distributed, the entire balance must be distributed. This restriction prevents plan participants, and ultimately their beneficiaries, from taking advantage of the convenience and possible tax benefits of partial distribution, systematic payments, or annuitization. IRAs, on the other hand, can provide greater flexibility by allowing these additional distribution options.

It may be advantageous for a spousal beneficiary to roll over the assets inherited from an employer sponsored retirement plan to an IRA. For example, if the beneficiary is the wife of the employee and the plan allows life expectancy payments, she will have to begin required minimum distributions (RMDs) calculated using the Single Life Expectancy Table.

By contrast, if she had rolled the inherited account into her own IRA, she could have waited until reaching age 70½ before beginning RMDs. The payments would then be calculated from the Uniform Lifetime Table, resulting in lower RMDs than distributions calculated from the Single Life Expectancy Table. Lower RMDs would allow the money the opportunity to continue growing tax deferred longer. Her beneficiaries may also be affected by her choice to leave the money in the plan. If she does not deplete the entire account, her beneficiaries must continue RMDs from the employer-sponsored retirement plan based on her life expectancy. However, if she had rolled the account into her own IRA, her beneficiaries may have been able to take payments over their own life expectancy, possibly stretching them longer than payments from an employer-sponsored retirement plan.

All rollover-eligible money withdrawn from an employer-sponsored retirement plan must have 20% withheld toward federal income taxes. In addition, 14 states impose mandatory state withholding taxes ranging from 2% to 8%. However, an IRA owner can elect to have no income taxes withheld and continue to invest that amount, allowing it the opportunity to grow tax deferred. Ultimately, all taxes must be paid, but the money to pay them does not need to come from the IRA.

Individuals under the age of 59½ are required to pay, in addition to income taxes, a 10% penalty tax on withdrawals from employer-sponsored retirement plans and IRAs, unless they qualify for an exception. Three exceptions for IRA distributions — a qualified first-time home purchase (lifetime limit of $10,000), certain higher education expenses, and health insurance premiums while unemployed — are not available for employer-sponsored retirement plan distributions. For additional details, contact your professional tax advisor

While recent tax law changes allow for greater portability of retirement accounts, many employersponsored retirement plans still have not adopted these rules, and many therefore do not allow money from certain types of retirement accounts to be rolled in. In addition, individuals generally cannot roll money into a former employer’s retirement plan. However, most IRAs generally accept the rollovers permitted by these recent changes. Qualified retirement plans, including some 403(b) plans and governmental 457(b) plans, can be rolled into an IRA. By consolidating these accounts, investors can reduce the number of statements they receive, eliminate redundant fees, and get a comprehensive picture of their retirement asset allocations. Combining accounts can also help simplify retirement distribution strategies.

By leaving money in a former employer’s retirement plan, individuals are restricted to the investments provided by the plan, and the offerings may be limited. Rolling over to an IRA can expand the number of investment options and the ability to diversify.

After reaching age 70½, individuals will have to begin RMDs. If someone has an IRA and two 401(k) accounts, for example, separate calculations must be done, and separate withdrawals must be taken from each account. The task is simpler for those who own only IRAs. All the balances can be aggregated (added together for calculation purposes), and the total required amount can be withdrawn from any one or more of the IRAs. This means less paperwork and simplified tracking. It also allows the investor to decide which investments to liquidate, and from which accounts.

[1] 403(b) plans can be aggregated with other 403(b) plans for RMDs

The importance of working with a financial professional should not be underestimated. He or she can assist an IRA owner with asset allocation, distribution planning, and retirement income strategies. Many employer-sponsored retirement plans do not offer this beneficial service.