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Changing Jobs: Smart Moves For Your Pension Plan I

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

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:

  1. 1 Take the money in cash
  2. 2 Leave it in your old company’s pension plan
  3. 3 Roll it over into your new company’s pension plan
  4. 4 Roll it over into an IRA

In each case, there a few additional factors we will need to consider.

  • Outstanding loans
  • Company Stock
  • Separation from service after age 55
  • Creditor protection

 

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.

Plan Loans
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.