One of the most important financial decisions that many people make involves the distribution of money from company retirement plans. Most companies don’t want the responsibility of administering accounts for workers who have retired or gone to work elsewhere. Today’s trend is toward “portable pensions” that workers can take with them from job-to-job, so that their retirement plan money can keep growing over whole careers, perhaps across many jobs.
However, many plan participants are not prepared to make the decisions about distributions that are necessary, if they are to achieve personal retirement goals. They don’t understand the choices available, and they may not anticipate decisions and seek professional help before deadlines occur. While this article doesn’t attempt to provide all the knowledge required, it does identify important issues to consider if you are about to receive a distribution.
Six Trigger Events
A good place to start is with the concept of a “trigger event.” This is an event at which your plan money is often distributed to you under the terms of the plan. The six most common trigger events are: 1) separation from service (i.e., quitting, being fired, being offered early retirement); 2) reaching retirement age; 3) reaching age 59 ½ in a plan that allows distributions after that age; 4) death; 5) disability; and 6) termination of the plan.
At a trigger event, participants normally are entitled to receive their vested plan balances, less any plan loans outstanding. For many people, this is the “biggest paycheck” they may ever handle, representing years of personal savings, employer contributions and accumulated earnings. Perhaps the most important point to make about handling a distribution involves the need to anticipate and plan for trigger events. If your company is downsizing and laying off workers, don’t wait for “pink slip day” to seek information or advice. Many other pressures may be swirling around you when the trigger event takes place, and you need time to plan for handling your “biggest paycheck” wisely. One of the first steps in planning for a trigger event is to understand all your choices for handling this money, and then select the best one for your future.
Your Choices Are Many
You will probably have several of the following choices for handling this money:
- Leave money in the plan and let it compound. Depending on the kind of plan it is, and its terms, you may or may not have this choice. If you do, however, leaving money in the plan means you will be limited to the plan’s investment choices. You probably won’t be allowed to put more of your own money into the plan after you leave work.
- Take an annuity income payout from the plan, if one is offered. This choice converts plan money into a fixed income guaranteed by an insurance company. However, once you accept this choice, you generally can’t change it. The annuity income may provide less purchasing power the longer you live, because of inflation.
- Pay tax on the distribution and invest or spend the after-tax amounts. This is usually not an attractive choice – especially if your biggest paycheck is large. The distribution will be added to your other income and could be taxed in the highest brackets. If you are under age 59 ½, the distribution also could be subject to a 10% federal tax penalty.
- Transfer the money to the plan of a new employer, if this option is offered. Tax law changes encourage transfers between companies and types of plans. To make this choice work, you generally need to have a new job lined up and take steps to make sure your money is transferred from one plan to another. In this case, you won’t owe current income tax, and all your plan money can continue to grow.
- You can transfer the money directly to a Traditional IRA in your own name, You must arrange this transfer between the company you are leaving and your choice of IRA provider. In this case, you do not actually receive money and there is no current income tax consequence.
- You can receive the distribution and then “roll it over” to a Traditional IRA in your own name. You must deposit money into the IRA within 60 days of receipt. The employer will withhold 20% of the distribution for federal income tax, so you will have to supply this amount yourself if you want to avoid tax and possible penalty on that portion of the money. It’s best to avoid the withholding issues of a rollover, if you can.
- You may transfer money to a Roth IRA, if you qualify. Roth conversions currently are available to taxpayers with modified Adjusted Gross Income of $100,000 or less. Starting in 2010, the income limit on these conversions is scheduled to disappear. In a Roth conversion, you pay current income tax on the converted amount and then can qualify for tax-free distributions later on.
Which Choice is Best?
These choices can be complex to evaluate. With so much money at stake, you need to make sure your analysis is thorough and considers your long-term needs. That’s why it usually pays to sit down with a financial professional well before a trigger event. Many professionals are able to help you understand the tax and investment consequences by using retirement distribution software and customized illustrations. They also can explain other choices you may have. When you consider how long and hard you have worked to earn your biggest paycheck, you should then decide that it’s worthwhile to make the most of it with qualified financial professional help.