BUSINESS & FINANCE :: DECEMBER 2007/JANUARY 2008

401(k): You Can Take It with You

Presented By: David F. Boothe

If you contribute to your employer’s 401(k) plan and leave your job, one of the biggest decisions you will make is what to do with the money in your plan.

Since the federal tax code was changed in 1978 to create 401(k) plans, many individuals have used this type of employer-sponsored defined-contribution plan to save money for retirement in a tax-deferred account. At the end of 2003, these plans had an estimated $1.9 trillion in assets, according to the Employee Benefit Research Institute.

But in our increasingly mobile society, changing jobs is a real possibility. What should you do with the funds you’ve accumulated in your 401(k)? If you are going to a new job, you may be able to roll the money into your new employer’s plan, but three other options may work better for the long term: withdraw some or all of it, leave it where it is, or roll the money over to an individual retirement account (IRA).

“Although it might be tempting to withdraw your savings to have more cash on hand, you will owe income tax on the distribution,” explains Ken Pardue, Manager of the Retirement Department for Wachovia Securities in Richmond, Va.

Getting Hit with Taxes

Most employers are required to withhold 20 percent of the account’s value when issuing you a check (if your tax rate is higher than 20 percent, you will owe the balance at tax time). And while there are some exceptions, if you are under age 59½, you will probably have to pay a 10 percent early-distribution penalty as well.

If your employer sends you a check (and most will do this automatically if funds in your account are less than $5,000), you’ll have 60 days to deposit the check into an IRA and contribute the 20 percent that was withheld for income taxes to the account to qualify for a tax credit. Otherwise, the money is taxed as a lump-sum distribution, which could result in paying more taxes than necessary, cautions Pardue.

Depending on your age, it might be worthwhile for you to leave some, or all, of your money in your former employer’s plan, provided the employer allows it. If you were 55 or older the year you left the company, and plan to tap into your 401(k) savings, you can avoid the 10 percent early-withdrawal penalty if the money is in your company plan.

Similarly, if you work past age 70½ and the money is in your former employer’s plan, you can delay taking required minimum distributions as long as you are still working.

Rolling the Money into an IRA

For many people, the best option is to roll the money into an IRA. “When you leave your job and roll your 401(k) savings into an IRA, you can save money in a tax-deferred account that offers you greater investment and estate planning options,” explains Pardue. Benefits include:

More investment options. In a 401(k) plan, the plan administrator chooses the investment options. With an IRA, you have the freedom to select from a range of investments, including mutual funds and individual stocks, which can help with proper portfolio diversification. You can also easily change how your money is invested, and you may have the option — depending on your income — of converting a Traditional IRA to a Roth IRA.
Flexibility in estate planning. With an IRA, you can name more than one beneficiary, have contingent beneficiaries, and in most cases, name someone who isn’t your spouse as a beneficiary — estate planning techniques that some 401(k) plans don’t allow. In addition, beneficiaries of an IRA aren’t required to take a lump-sum distribution and pay taxes at that time, so the money can continue to grow tax-deferred as an inherited IRA or a “Stretch” IRA.
Immediate access to your money. There are no restrictions on when you can take money out of your IRA; the only drawback is that you will pay federal and state income taxes on the withdrawal, as well as (in most cases) a 10 percent early-distribution penalty if you are under age 59½.
Penalty-free withdrawals. In certain circumstances, you may be exempt from the 10 percent early-distribution penalty — for example, if withdrawals are used for higher education expenses for yourself, your spouse, or your children or grandchildren. You can also make penalty-free withdrawals ($10,000 lifetime maximum) from your IRA to put toward a principal residence that is a first-time home purchase for you or your spouse, child, grandchild or ancestor.

If your 401(k) assets are invested in your employer’s highly appreciated stock, you might consider taking a distribution of all or part of the stock and transferring the remainder of your account to a rollover IRA. With this approach, you would only pay income taxes on the cost basis of the stock when it was acquired in the plan. Taxes on the amount that the stock has appreciated are due when the stock is sold, and that appreciation could be taxed at the long-term capital-gains rate — which might be lower than your income-tax rate.

If you roll money from your 401(k) over to an IRA, make sure it’s a direct trustee-to-trustee rollover from your employer’s plan to the IRA account you have opened at a financial institution. This way, you won’t be required to pay federal and state income taxes on the transfer; taxes will be due only when you withdraw the money.

“It’s a good idea to open a new IRA when you roll the money over,” explains Pardue, “so that you are eligible to transfer the money to another IRA or to your new employer’s 401(k) plan.”

Weighing these options can be complicated, and your financial advisor can be an invaluable resource as you consider the advantages and disadvantages of each approach.

Wachovia Securities does not render legal, accounting or tax advice. Please consult your CPA or attorney on such matters.

Provided by courtesy of David F. Boothe, President and Financial Advisor with BIG Investment Services in Dover, DE. For more information, please call Mr. Boothe at 302-734-7526. Investment products and services are offered through Wachovia Securities Financial Network, LLC (WSFN), member NASD and SIPC, a registered broker-dealer and separate nonbank affiliate of Wachovia Corporation. BIG Investment Services is a separate entity from WSFN. ©2005 Wachovia Securities, LLC.

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