With the spectacular returns the stock market has provided the past few years, many people have seen a dramatic increase in the assets in their 401(k) accounts. In a survey last year, the Employee Benefits Research Institute found that the average 401(k) account balance for plan participants in their 60s was over $87,000. Even more impressive, the average account balance for plan participants in their 60s with 30 years of tenure was more than $185,000. When you retire and must take a distribution of these assets, potential tax liabilities and other considerations can make the decision difficult. Federal legislation has removed key tax advantages for taking lump-sum distributions.
However, tax laws do continue to provide favorable treatment for taking certain distributions. If you’re planning to retire soon, you need to know your options for taking distributions of your 401(k) assets. If you don’t need to use the assets in your employer’s retirement plan immediately, your best choice may be an IRA rollover, which will allow your retirement assets to grow tax-deferred until you begin taking distributions.
Rules For Taking 401(k) Distributions
Since an eligible rollover is not subject to taxation at the time of the rollover your assets continue to grow tax deferred. As a result, you may want to keep your money invested in your IRA as long as you can. However, the rules for when you can and have to take distributions from your IRA and pay taxes are a bit tricky. Generally, you can take withdrawals from an IRA starting at age 59 1/2 without incurring a tax penalty, but you are not required to begin taking withdrawals until April 1 of the year after the year that you reach 70 1/2. At that time, you must begin to withdraw a minimum annual amount based on your life expectancy or the joint life expectancies of you and your beneficiary. If you don’t withdraw the minimum required amount in any given year, you’ll be subject to a 50 percent excess accumulation penalty on the portion not withdrawn. If you have rolled over your assets from an employer plan into an IRA, you can access the money at any time for any reason. However, if you are under the age of 59 1/2, you may be subject to a 10 percent early withdrawal penalty unless an exception applies. If you need your assets from an IRA before age 59 1/2, you can avoid the 10 percent penalty, provided certain requirements are met, if you take payments in substantially equal amounts based on an IRS-approved calculation, over a period of five years or until the age of 59 1/2, whichever is longer.
When A Rollover May Not Be The Best Option
While taking an IRA rollover is not taxed at the time of the eligible rollover it may in fact be better to take a taxable distribution and take advantage of other favorable tax treatments.
This is especially the case if you plan to use the money sooner than later and not take full advantage of an IRA’s tax deferred growth. What follows are two additional options:
o 10-Year Forward Averaging
If you need to tap all or part of your retirement plan assets, you’ll have to pay taxes on your distribution regardless if it comes out of your 401(k) or an IRA. However, 10-year averaging is available to employees born before Jan. 1, 1936, who have been in their company retirement plan for at least five years. For tax purposes, 10-year averaging treats a lump-sum payout as if it were your only income and you had received it over 10 years in equal installments. But, to take advantage of 10-year averaging you need to take a qualified lump sum distribution directly out of your employer’s plan and not rollover to an IRA.
Special Tax Treatment For Employer Stock
If your 401(k) plan has qualifying employer stock, you may be able to take advantage of another special tax treatment. But if you roll these assets to an IRA this special tax treatment is lost. Distributions generally are taxed as ordinary income on the fair market value of the assets when they are distributed.
When you receive employer stock, however, ordinary income taxes are paid on the cost basis of the shares , the value of the shares at the time they were acquired , rather than the current market value. The difference between the cost basis and the stock’s current value , called the net unrealized appreciation , is not taxed until the stock is sold later after the distribution. Taxation on the net unrealized appreciation is at the long-term capital gains rate of 20 percent, which could be significantly lower than your ordinary income rate. If your intention is to hold the employer stock, depositing the employer stock in a non-retirement account may be the best option for you.
o Leaving It With Your Employer
Of course, leaving it in your employer’s plan may be the appropriate option. If your account balance is more than $5,000, your 401(k) plan may allow you to keep your money invested in your employer’s plan until April 1 following the year in which you turn age 70 1/2.
Alternatives To Employer’s Plan
You may, however, be able to earn a better return on investments of your own choosing outside your employer’s plan, so it is important to research your options. Also, if you find you want to use the funds before age 70 1/2, your 401(k) plan may have certain restrictions, such as requiring you to withdraw your money in certain amounts for a specified number of years or for an amount of time based on your life expectancy. If you choose to leave your assets in your employer’s plan, you may be able to elect to take substantially equal distributions at least annually that will last more than 10 years. The distributions generally will not be subject to the 10 percent early withdrawal tax if you’re under 59 1/2, but it can’t be rolled over into an IRA. But remember, once you begin taking distributions, you won’t be able to change the amount of money you receive. Many of the decisions that you make in choosing how to receive assets from a 401(k) plan are irrevocable and have significant implications for the timing and amount of income taxes due. In fact the wrong decision from a tax perspective can take away much of the returns the unprecedented bull market provided. It’s a complex decision, so our best advice is for you to review your individual situation with your tax advisor and a financial consultant before taking action.
Coghlan is first vice president, financial consultant, and certified financial manager for the Downtown San Diego branch of Merrill Lynch.