You can end your ties to your employer’s plan by taking your money out.
Moving assets out of your employer’s pension or retirement savings plan may be a smart decision — or just the opposite. On the plus side, you may have more control over the way you invest your assets and more flexibility in the way you take income.
But, if the investment options in the plan are strong and the fees are low, you may find that, by severing your ties to the plan, you must assume more responsibility for managing your account at the same time you’re spending more to maintain it. Remember, too, that assets in employer plans and IRAs are protected against claims by your creditors, but distributions from those accounts are not.
How lump sum payouts work?
Some but not all employer plans permit lump-sum distributions from a defined benefit plan. In that case, your employer figures out how much the plan would have paid you as an annuity over your projected lifespan and then calculates how much the pension fund could have earned on that amount during the years of your payout. Your lump sum share is what you would have been entitled to, reduced by a factor of the projected earnings known as the discount rate.
In contrast, if you take a lump-sum payout from your defined contribution plan, such as a 401(k) or a 403(b), and you’re vested in the plan, you are entitled to the total account value, minus any outstanding loans.
Your plan description will explain the process your employer will follow to transfer assets. One approach is to liquidate the assets and transfer the money either to you or directly to an IRA. Another is to make an in-kind transfer. In that case, stocks, ETFs, mutual funds or other assets you hold in your plan account are moved directly to the custodian of your IRA.
While transfers can be the easiest solution, saving both the time and any potential costs of selling and replacing the asset, it may not always be possible. That’s especially true if the investments you hold in your plan are proprietary mutual funds from the plan provider.
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Investing a lump sum
One challenge in investing a lump sum payment is how to put your assets to work without feeling that you’re rushing or making snap decisions. It is true that the sooner you invest, the more potential your principal has to grow. But that advantage can disappear if you haven’t developed a strategy for building a diversified portfolio and selecting appropriate investments.
One approach, if you aren’t planning to begin taking income from the account in the next few years, is to purchase stocks and bonds, either directly or through exchange traded funds (ETFs), mutual funds, managed accounts, or other investments for a combination of current income and long-term growth.
If some investments grow in value, you can gradually sell them and reinvest for income or capital preservation. You’ll owe tax on any profit at your long-term capital gains rate, which is lower than the rate on income from a tax-deferred plan.
These investments might include dividend-paying stocks, tax-exempt municipal bonds, Treasury issues, highly rated corporate bonds or bond funds, and publicly traded REITs or limited partnerships. Your choices depend on your appetite for risk and your financial situation.
Moving to an IRA rollover
You can move the money from your retirement account to an IRA in two ways:
- You can get a check for the money, in a lump sum payout, and deposit the full amount in the IRA within 60 days
- You can have the money transferred directly to the custodian of your new or existing IRA
The advantage of taking the cash is that you can use the money for 60 days before the rollover deadline. That flexibility can be outweighed by the fact that your employer must withhold 20% of the amount for federal income tax before giving you the rest, to cover what you’ll owe if you don’t complete the rollover. This means you have to come up with money from other sources so you can put the full amount in your IRA. Any amounts you don’t deposit within the time limit are considered withdrawals and are taxed at your regular rate. If you’re younger than 591 ⁄2, you may also owe a 10% tax penalty in addition. The exception is if you’re over 55 and have stopped working. Then the penalty may be waived.
When the money is transferred directly, nothing is withheld, and you don’t have to worry about missing the 60-day deadline. That makes it the method of choice for many people. It can also reduce any temptation to spend the money.
If you purchased company stock through a 401(k) or other employer plan or if your employer contributed stock to your account, you may want to take the stock as a lumpsum distribution instead of rolling it into an IRA along with other plan assets. You’ll owe income tax on your cost basis, or the value of the stock when it was added to your account. But no tax is due on any increase in value until you sell. Then any profit is taxed at your long-term capital gains rate.
That’s lower than the rate you’d pay if you sold the shares within an IRA and withdrew the proceeds. In addition, if you’re planning to leave assets to your heirs, there may be some advantage to your owning the stock outright rather than in an IRA. But whether this approach is the best for you depends on several complex factors. It’s essential to get professional advice.
Unless you plan to spend the bulk of your retirement payout right away — a decision you’ll want to weigh carefully unless you have other sources of retirement income — you have the opportunity to roll over the account value into either a traditional or Roth IRA. If you choose the traditional account, no tax is due on the amount you move. You can either make the transfer into an existing IRA or open one or more new ones, either to make different types of investments or to name different beneficiaries for each account.
Or, if you prefer, you can pay the income tax that’s due and convert the balance to a Roth IRA. There is no income cap limiting who is eligible to covert plan assets to a rollover Roth IRA, as there is limiting contributions to a Roth IRA.
Or, if you’ve participated in a Roth 401(k) or 403(b), you can simply roll over those assets to a Roth IRA. A big difference between remaining in the Roth 401(k) or 403(b) and rolling over is that distributions are required from an employer plan even though the distributions aren’t taxed if your account has been open five years and you’re at least 59½. That’s not the case when you convert. No withdrawals are required in your lifetime.
Should You Move Money Out Of Your IRA? by Inna Rosputnia
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