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Leaving Your Current Job? You Have Retirement Plan Options

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Part 1 of a 2-part series

Posted April 18, 2012



It is time to examine six options individuals have for their retirement plan benefits when they leave an employer. At some point in their lives, most workers will find themselves in this situation and they need to be as adequately informed as possible in order to make the best choices for themselves and their families.

Whether you are changing jobs, being laid off or simply retiring you will be faced with many decisions. One key decision will be what to do with the vested money you have accumulated in your prior employer’s retirement plan, whether its a 401(k) plan, 403(b) plan or a pension plan that allows you full access to your benefit, such as a cash balance plan. Among the options to consider may be:

We will cover the first three options in this article and the last three choices next Monday.

Rolling over to a Traditional IRA

One of the most compelling reasons to roll over the money to a Traditional IRA is to facilitate the “stretch-out” opportunity. At your death, your beneficiaries can stretch distributions over a period of time equal to their own life expectancies. Many plans do not allow the stretch option even though the IRA rules permit it. Plans generally do not want to get involved with the administrative burden of keeping track of a deceased employee’s beneficiaries. Thus, some plans simply pay the account balance to beneficiaries over a short time period at best.

Estate planning can be enhanced by rolling over the assets to a Traditional IRA. IRAs offer the option of splitting accounts and naming multiple primary and contingent beneficiaries. Funds in a company retirement plan are subject to federal spousal protection laws that, for the most part, require participants to name their spouse as beneficiary for a least 50% of the account unless the spouse signs a waiver to consent to a different designation. With an IRA, you could name anyone you want as beneficiary, although some state laws do provide a default interest to the spouse even if he or she is not designated as a beneficiary.

Unlike many company plans, you do not have to select from a limited number of investment options within a Traditional IRA; you have a wide range from which to choose. You can even purchase an annuity that offers an annually increasing guaranteed death benefit that just might prove to be a great investment option in a volatile market. Further, Traditional IRAs have no withdrawal restrictions while company plans generally have some restrictions on withdrawals prior to age 59½. With an IRA, you have immediate access to your funds, regardless of your age.

On the downside, some protection from creditors may be lost when the funds move from an employer-sponsored retirement plan to an IRA. Under federal law, assets held in most employer plans receive unlimited protection from a participant’s creditors. With IRAs, that protection is determined under state statutes which may not be as paternalistic in nature. Thus, it’s important to know what protection you might be giving up to the extent you roll your assets into an IRA.

Lump Sum Distributions

A lump sum distribution is the payment of your entire vested account balance in one calendar year due to your (a) attainment of age 59½, (b) separation from employment (not for self-employed individuals), (c) death, or (d) disability (only for self-employed individuals). You generally would choose this option if you need the money to live on or if you’re eligible for special tax benefits due to your age or investment holdings. By withdrawing the money it will be subject to income tax, with the exception of any after tax contributions you previously made that are returned to you. This obviously is a very expensive option. However, there are two things to keep in mind: Net unrealized appreciation (NUA) and ten-year forward averaging.

If your company plan includes highly appreciated company stock, consider withdrawing some or all of the stock and rolling the rest of the plan assets over to an IRA or take it in cash. To the extent you do this, you will pay no current income tax on the NUA (the appreciation in the value of the stock while it resided in the company plan.) The cost of the stock to the plan (the basis) of the shares distributed will be treated as ordinary income in the year of delivery to you. The NUA will be deemed a long-term capital gain at whatever point the stock is sold, regardless of how long you or your beneficiaries have held it. There are many rules to follow so you might want to consult your financial advisor or professional who has special knowledge in this area.

Ten year forward averaging is only available if all the assets are distributed this way (i.e. no rollover of any portion to an IRA or another employer plan.) Also, it applies only if the plan participant was born prior to January 2, 1936. Capital gain rates can be used for any part of a lump sum distribution that is attributable to plan participation before 1936. The special ten-year averaging tax is a stand-alone calculation and is figured separately from regular tax, so the distribution is not added to your adjusted gross income. The tax is computed using the single filer tax rate that was in effect for 1986.

Unfortunately, taking a lump sum distribution means these assets will no longer enjoy the tax-deferred umbrella afforded by a qualified retirement plan. All future earnings will be taxable when earned.

Leaving it in the Plan

There are very few valid reasons for leaving retirement benefits in a company plan. Probably the most compelling one is inertia. Sometimes, people just don’t want to make a decision when it comes to these assets. Truly valid reasons may include: federal creditor protection afforded plan assets, the existence of outstanding plan loans which would become taxable if you leave the plan, owning life insurance in corporate plans, and, finally, being able to take distributions prior to age 59½ without being subject to the 10% early distribution penalty if you leave the employer in a year in which you are age 55 or older (for public safety employees, this age is 50).

Next time, we’ll explore further options for handling your company retirement plan money.

Ed Slott and Company has been called "The Best" source for IRA advice by The Wall Street Journal, and "America's IRA Experts" by Mutual Funds Magazine. Ed is a widely recognized professional speaker and author. Get more IRA information from America's IRA Experts.

 

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