Smart Moves 1
Smart Moves for Your Pension Plan
If you are changing jobs, one of the many big decisions you will face is what to do with your pension plan. You have four basic choices, each with its own pros and cons:
In each case, there a few additional factors we will need to consider.
This article deals with the first option:
Take the money and run!
Taking the money and spending it is not one of the smart choices we will be talking about. The most important reason for not blowing the money is that you shouldn’t be systematically looting your retirement account. Keeping the money growing in a tax deferred environment until you actually need it for retirement is an enormous benefit. The IRS gives you this huge advantage in the hopes that we won’t have to support you on welfare tomorrow.
Just in case you didn’t get the hint, the IRS has devised some pretty draconian treatments for those withdrawing funds before normal retirement age. They really don’t want you to finance your next car or vacation with your pension distribution.
For starters, if you are under age 59 ½, the pension will be required to withhold 20% to cover part of the enormous tax you are going to owe. But, it gets worse. Because you are paying tax on the distribution at ordinary income tax rates, you may have a tax rate of up to 39% on the entire distribution. So, at the end of the year, you may very well have a severe tax deficit, and penalty if you didn’t properly withhold on your quarterly filings. Unless you fall under one of the exemptions for death, disability, etc, you may also be penalized an additional 10% for early withdrawal. And, of course, if you live in a state with income tax, the state may further delete your remaining balance.
Let’s look at an example to see just how bad this might be. Sally is a 30 years old attorney, has a pension balance of $50,000, and just got an offer at a competing firm for with a huge raise. She thinks it might be neat to show up driving a new red Miata. Here is how that would work out.
Total Distribution $50,000 Less 20% withholding -$10,000 Net Check to Sally -$40,000 Additional Taxes Due (39% rate) -$9,500 Penalty Tax 10% -$5,000 Net Proceeds $25,500
Almost half of Sally’s distribution evaporated. It’s gone off to the IRS, never to be seen again. In case you haven’t noticed, the IRS is like the Roach Motel. Your money can go in, but it’s not coming back out!
If Sally decides to roll over the account within the 60 day window but after she receives the check from the plan administrator, she will have to dip into her pocket or borrow the $10,000 that was withheld in order to complete the rollover. She can file for the refund the following year when she does her taxes.
If she doesn’t fund the missing $10,000, but rolls over the $40,000 net she received, she will owe taxes and possibly penalties on the $10,000 that was withheld.
If Sally’s plan had had an existing loan, it gets even worse. Suppose she had borrowed $25,000 to remodel her kitchen sometime in the past. Almost the entire proceeds would be eaten away by taxes and penalties because she is deemed to have made a taxable distribution when she defaults on the loan.
Total Distribution $50,000 Loan Repayment -$25,000 Less 20% withholding -$10,000 Additional Taxes Due (39% rate) -$9,500 Penalty Tax 10% -$5,000 Net Proceeds $500
Systematically looting your retirement funds
The real problem in these transactions are that Sally has impoverished herself in her old age. Employees that withdraw their pension funds are systematically destroying their own retirement benefits. Had she left the proceeds at work earning even 9% in a tax deferred account, by the time she turns 60 the balance would be $663,384. At 65, the balance should be $1,020,698, and she could comfortably withdraw $60,000 a year forever. Pretty expensive little red car!
Age 55 Separation from Service
If we change the facts a little to make Sally age 55 or older when she “separates from service”, then because the funds come from a qualified plan, Sally receives an exemption from the 10% penalty tax. However, if the funds go into an IRA and are then withdrawn, prior to age 59 ½, the penalty would apply.
If Sally is taking an early retirement after age 55 but before age 59 1/2, and if her plan allows it, then funding her retirement needs from plan distributions may in fact make sense.
Company stock If part of Sally’s account had been made up of company stock, then Sally might benefit from another little known provision. She could withdraw just the stock and pay taxes only on the cost basis that the plan had in the stock. Later when she sold the stock for whatever reason, she would pay capital gains on the difference between the cost basis and sales price. This might be very attractive to a participant with a large balance of company stock at a very low basis. So, to use an absurd example, suppose the entire account was company stock and the basis was $1.00. Sally would pay ordinary tax on $1.00 when she had the stock distributed to her. Later when she sold it, she would pay capital gains rates on the difference between the $1.00 and the sales price. In some very rare situations, this might compare favorably with a rollover on an after tax basis. However, the benefits and costs will have to be computed for each unique situation.
Reinvesting the net proceeds Instead of the little red Miata, Sally might be considering re-investing the net proceeds to grow for retirement. However, it’s unlikely that she could ever make up for the loss of capital she incurs by paying the taxes so many years in advance. Deferral is a powerful wealth accumulation technique. Keeping all those dollars at work in a tax deferred environment is a huge advantage not easily matched.
Creditor proofing Funds withdrawn from a qualified pension account lose their federal protection against creditors. This could be devastating if a future lawsuit award exceeds available insurance coverage, or in the event of a bankruptcy.
Conclusion Keep time and the valuable benefit of continued deferral on your side by keeping your retirement plans at work for you. Resist the temptation to blow the money. Taking the money is not an option you should consider.
Smart Moves 2
Hopefully, you won’t be tempted to take the money and blow it. The advantages of deferral are just too great to pass up. Having eliminated that as a possibility, let’s look at whether you might consider leaving your funds with your old employer’s plan.
In the vast majority of cases, the employee is best served to roll over his funds. However, a few job changers will find that leaving their funds in their old employer’s plan may meet their needs. However, each will have to consider their individual circumstances to come to the right decision. Let’s look at the pros and cons.
Reasons to remain in the old plan:
Low costs, and wide menu of investment choices: While it’s generally not the case, a few employers offer superb, low cost plans and subsidize the administrative costs rather than pass those costs on to employees. Better 401(k) or pension plans may offer almost unlimited choices of low cost funds from which a very sophisticated plan can be crafted. If you are satisfied with the plan costs, features, and investment choices, there may be no compelling case to withdraw your funds.
Asset Protection: Qualified pension plan assets enjoy federal protection from most creditors under ERISA (There are exceptions such as divorce settlements under a QUADRO (Qualified Domestic Relations Order)). This same level of protection may not be available under your state laws for IRA’s. Statutes differ from state to state. If there is a significant chance that you might have a claim that exceeds your insurance protection, and your state offers a low level of creditor protection for IRA’s, you might be wise to leave your assets inside a qualified plan.
Early Retirement between ages 55 and 59 1/2 Qualified plans have a big advantage over IRA’s for an employee that needs income from their plan if they have reached age 55 when they separate from service. There is no 10% early withdrawal penalty for distributions from a qualified plan. But, once the money is rolled into an IRA, withdrawals before age 59 ½ it will be subject to the penalty unless you qualify for one of the exemptions (death, disability, etc.) or set up a withdrawal plan under section 72(t). Because the 72(t) withdrawal plans lack flexibility this may be an important consideration. (Note: you may not use this feature unless you worked until age 55 and then separated from service. For instance, you couldn’t separate from service at age 53, wait two years, and then begin taking penalty free withdrawals.)
Reasons to look elsewhere:
Your old employer may force you out: Employers aren’t usually anxious to provide services to former plan participants. The time and money are direct costs of doing business, better spent on existing employees. For instance, keeping track of former employees’ addresses, providing statements and summary plan descriptions and other required overhead mount up to a substantial sum over time. So, a majority of employers require that terminated employees make other arrangements for their accounts.
Limited investment choices: Few 401(k) plans provide the wealth of investment choices necessary to execute a sophisticated asset allocation plan, or coordinate with your other investments not held in the plan.
High costs: Many 401(k) plan costs are unacceptably high. Total costs may easily exceed 3% per year or more. Saving one or two percent a year in plan costs can add up to a fortune over your career.
Control: 401(k) plans offer little control over when and how to use the capital. On balance this is a very good thing. Employees that use their retirement plans to finance vacations or purchase consumer goods systematically plunder their future security. On the other hand, in a dire emergency access to the funds might be valuable. Other plans may make it difficult to re-align investment strategy to meet the participants changing needs.
Consolidation: Today’s mobile work force job hop at a dizzying pace. Some will find themselves with multiple retirement accounts with past employers. It quickly becomes difficult to properly manage all these accounts, design a comprehensive investment plan, or obtain a global view of account performance.
One final consideration: loans
If you have an outstanding loan when you leave your old employer, you must either pay it back, or be taxed on the amount of the loan as a distribution. Loans from pension plans must be repaid by payroll deduction. If you aren’t on the payroll, you can’t continue the loan payments, which will trigger a distribution report to the IRS.
Smart Moves 3
The number of people that actually roll over their pension plans from one employer to another is very, very small. Most will find that a rollover to an IRA better fits their needs. Still, in certain situations, it may be your best option.
Note: If your old employer plan contains low basis company stock, it would lose its special treatment if rolled over into either an IRA or your new company’s plan. If you find that it is an advantage to take a distribution of the company stock for tax purposes, do it first, and then roll over the balance.
The Conduit IRA
If your intent is to roll over your pension plan into a future employer’s plan, but don’t yet have employment lined up yet, you can still position yourself for a later rollover. Just open an IRA that consists solely of proceeds from a qualified plan, and then at a later time you can roll over into the new company’s plan. Make sure that the conduit IRA does not co-mingle funds any from a traditional IRA.
Smart Moves 4
After you have considered all the other possibilities, you will most likely find that your best choice for your pension funds is the IRA rollover. Unless you fall into one of the rare situations outlined in the previous sections, the advantages are overwhelming:
Accomplishing the rollover: It’s important to avoid any receipt of the funds that might trigger an unanticipated tax consequence. The “Trustee to Trustee” transfer prevents any possibility of a taxable event occurring during the transfer process. (If you do decide to hire an investment advisor, they will assist you to compete the process.)
The average American changes jobs about once every three and a half years. That means that a person could easily switch jobs more than ten times over their career.
Even though 401(k) plans are touted as being “portable”, every job change is a potential loss of retirement benefits. And a woman that interrupts her career for parenting is further disadvantaged. Cumulatively these losses could be catastrophic to your retirement security even if you never lose a single day of work when changing jobs.
You can’t afford to lose out on retirement accumulation. You have to keep that money in play, working hard for your future. Fortunately, there are tactics to minimize the impact to your retirement planning.
First, let’s look at how these losses come about:
Another serious issue is “leakage” of retirement plan assets which occurs when an employee cashes out his retirement as he leaves his employer. Even with mandatory 20% withholding, ordinary income tax and a potential 10% penalty for premature withdrawal, far too many participants take the money and run. Rather than keep the money hard at work in a tax deferred plan, employees that fail to roll over their termination benefits systematically loot their future economic security.
Finally, some employees make no election and their funds remain in the old employer’s plan. This might work out OK, but more likely will result in multiple unmanaged orphan accounts with no coherent investment strategy and potentially higher costs. (See Smart Moves for Your Pension Plan for a complete discussion of alternatives.)
None of this bodes well for a successful, prosperous and secure retirement. So, you will need an active strategy to minimize the disruption to your retirement plan accumulation.
Take Charge: If possible, time your exit to maximize your vesting, years of credited service, and accruals. It is surprising what a huge difference a day or two at the end of a plan year can make to your benefits.
Unless you have a severe financial crisis, preserve your qualified plan assets inside a tax sheltered vehicle that you can effectively, economically, conveniently and efficiently manage. Whether you keep your funds in the old employer’s plan, roll them into the new, or consolidate them into an IRA, your goal should be wide diversification, low cost, and a tailored solution that meets your needs. You have to keep those funds at work for your future security.
Not being covered by a plan is not an excuse to stop saving. There are plenty of alternatives to pension plans for transitioning workers. If you have a period of time where you are not covered by a plan, contribute to IRA’s, Spousal IRA’s or a tax efficient brokerage account.
If you are being recruited, always negotiate to make up for lost benefits. It can’t hurt to ask, and your new employer may be much more sympathetic than you imagine.