In this episode, podcast host and author of “Control Your Retirement Destiny” Dana Anspach covers Chapter 7 of the 2nd edition of the book titled, “Company Benefits.”
Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Chapter 7 – Podcast Script
Hi, this is Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of Control Your Retirement Destiny, a book that covers all the decisions you need to make as you plan for a transition into retirement.
This podcast covers the material in Chapter 7, on company benefits.
If you like what you hear today, go to Amazon and search for Control Your Retirement Destiny. Or, if you are looking for a customized financial plan, visit sensiblemoney.com to see how we can help.
Let’s take a look at company benefits, and how you make the most of them.
Company benefits used to be simple. Our grandparents, and in some cases our parents, worked for the same company for 25 or 30 years and retired with a gold watch and a pension.
Today, instead of pensions, most people have 401(k) plans. Now, you must decide how to invest your money, and when to take it out. In addition, you may have deferred compensation plans, stock options and various insurance benefits – ALL of which require you to make decisions.
Company benefits are far more complex than they used to be.
There are too many benefit programs out there to cover them all. Today we’re going to focus on the most common benefit option – the 401(k) plan. The goal is to show you how to use this type of retirement plan in a way that BENEFITS you the most.
There are four key things I want to cover:
The creditor protection rules that apply to your 401(k).
The age-related rules that impact when you can access your money and how it is taxed.
How to pick investments in your 401(k).
What to consider when you are deciding whether you should leave your funds in your 401(k) plan, or roll them over to an IRA.
First, creditor rules.
Your 401(k) assets cannot be touched by your creditors, even in the event of bankruptcy.
Hopefully, you’ll never need these rules. But, let me share with you a few real-life situations and how these rules apply.
Suppose you get a great business idea. You are 100% sure it will work out – but in order to get it going you need a little cash. “Hey,” you think, “I’ll just borrow it out of my 401(k) plan.” Or, maybe cash in the 401(k) account.
If your business does not work out, your 401(k) money is gone.
Instead of using 401(k) money for a start-up business, use credit cards, or a bank loan. If you use a bank loan, and your business doesn’t work out, the worst case is that you file for bankruptcy—your 401(k) assets would then remain protected and still available for your retirement.
Another situation that many people found themselves facing in 2008 and 2009 was a job loss. After losing their job, they, of course, didn’t want to lose their home, so many cashed in their 401(k)s to continue making their mortgage payments. Unfortunately, many used up all their retirement funds and then lost their home anyway.
Making objective decisions about one’s home can be difficult, but as difficult as it may be, you need to look at the long-term consequences of any financial decision. In a job loss situation, you may spend a substantial amount of retirement money trying to keep a home that you end up losing. One lady I spoke with said, “The stupidest thing I ever did was cash out my 401(k) plan to try to keep that house.”
Your 401(k) money is for retirement. That’s it. Don’t use it for any other purpose—particularly if you are in financial trouble. Using your 401(k) money before retirement voids a valuable form of protection that is available to you.
You know why pensions worked out so well for prior generations? Because they COULD NOT use them before retirement. You need to treat your 401(k) plan the same way.
Next, let’s talk about some of the odd age-related rules that apply to 401(k) plan withdrawals.
While you continue to work for a company, most of the time you can’t withdraw money from that 401(k) plan. Some plans offer hardship withdrawals, some offer loans and sometimes there is something available called an in-service withdrawal if you are age 59 ½ or older – but most of the time while you are still working there – you can’t access the funds.
But let’s say you change employers and now have money in a 401(k) plan from some place you previously worked. Then what can you do?
Usually you have a few options:
You can leave it there.
You can roll it over to an IRA and there are no taxes when this is done correctly.
You can roll it to a new 401(k) plan and there are no taxes when this is done right either.
You can withdraw it and pay taxes and possibly penalties.
Let’s talk about option 4, withdrawing it. That’s where the age-related rules come in.
When you withdraw money from a 401(k) plan you are taxed on it. If you take money out of a 401(k) plan before you reach the age of 59 ½, in addition to regular taxes, a 10% early withdrawal penalty tax also applies.
Here’s what many people don’t know. There’s an odd rule about the age of 55. Let’s say you leave your employer AFTER you reach the age of 55, but before age 59 ½. Even though you are not 59 ½ yet, you can now access the money in that old 401(k) plan without paying the early withdrawal penalty tax.
This early access rule DOES NOT apply if you roll the funds to an IRA or to a new plan. It also DOES NOT apply if you leave that employer BEFORE you reach the age of 55.
Here’s what you need to remember. If you leave an employer after you attain age 55, but before age 59 ½, don’t automatically move the funds to an IRA or to a new employer plan. If you want to preserve your ability to access the funds penalty-free, you’ll leave the funds, or at least a portion of them, in your prior plan.
And, if you’re a public safety employee – this early access rule kicks in at age 50 instead of age 55!
In general, a public safety employee includes firefighters, police, emergency medical service employees, as well as air traffic controllers and customs and border protection officers. The IRS has a comprehensive list that you can check to see if you qualify for this definition.
When you move past the early-access age of 50 or 55, the next important age is 59 ½. Once you attain age 59 ½, the penalty tax on withdrawals goes away. Regular income taxes, however, still apply.
And, keep in mind, a rollover or transfer, where you move money from one plan to another, or from a 401(k) to an IRA, does not trigger taxes. I talk to many people who think if they withdraw funds from a plan at all – even in the form of a rollover – that they will have to pay taxes and possibly penalties. A rollover or transfer is a special rule in the IRS code that allows you to move money from one retirement plan to another WITHOUT triggering the taxes or penalties.
The last critical age is 70 ½. At this age the IRS requires you to begin withdrawing money from 401(k)s, from IRAs, and from other types of retirement plans. There is a formula you must use each year to calculate the required withdrawal. This formula uses your year-end balance, along with the divisor that is based on your age.
Here’s an example: Lynn is retired and reaches age 70½. Her IRA balance on Dec 31st for the previous year is exactly $350,000. Based on her age, the divisor Lynn must use is 27.4. She takes the year-end balance of $350,000 and divides it by 27.4 to calculate the $12,773.72 that she must take out.
When she takes it out she will pay taxes on that amount. The distribution period decreases every subsequent year. For example, when Lynn is 88 years old, she will divide her retirement account balance by 12.7 to determine how much she must withdraw. If her account balance is still $350,000 that would be $27,559 that she must take out.
You can always withdraw more than the required amount, but if you withdraw less, you could be subject to a 50% excise tax on the amount you did not withdraw in time. Yikes – 50% is a hefty tax. You want to make sure you take your required distributions (RMD).
One thing to keep in mind - with a required distribution the money has to come out of the IRA account, but that doesn’t mean you have to spend it. One option is you can distribute investments, shares of a mutual fund or a stock, for example, and just move them out of your IRA account, into your brokerage account.
Since the money came out of the IRA, it satisfies the RMD, but the funds remain invested.
Another option is to make a charitable distribution. There’s something called a Qualified Charitable Distribution or QCD. You can distribute funds right from your IRA to a charity. There are some tax benefits to this, and it’s beyond the scope of this podcast for me to go into all the details, but if you don’t need the money from your IRA, it’s something you might want to look into.
But what do you do if you are still working at 70 ½?
Well, if you are not a 5% owner of the company you work for, you may be able to delay your required minimum distributions from your current employer plan until April 1st of the year after you retire. In this situation you are still required to take distributions from other retirement plans, just not from the one from your current employer.
Next, let’s talk about how to make better investment decisions in your 401(k).
If you are like a lot of people, you collect investment accounts over time. Maybe a 401(k) at one place, but then you leave that employer and leave the 401(k) plan there. You might open an IRA a few years later while you’re self-employed. Then start another 401(k) at a new employer a few years after that.
And if you’re married, your spouse may also have their own collection.
Rarely is this collection of investments aligned toward a common goal.
Instead, most people tend to pick investments in a rather random way. Some look at what has recently had the highest performance and pick that. Other people go with something that sounds familiar. Some ask a co-worker. And, some are more thoughtful and do a little bit of research.
Even if you are the research type, do you look at your investment portfolio as a household, or do you look at each individual account on its own?
Suppose, for example, that your 401(k) plan offers a great low-cost S&P 500 index fund, while your spouse’s 401(k) plan offers only high cost growth funds, but also has a safe option called a stable value fund? Or if your single, maybe it’s that you have one set of funds available in a 401(k) and other choices in your IRA.
If you are investing as a household, rather than balance each account, you might load up on the S&P fund in one account, while using more of the stable value fund in the other account. Although each account is not balanced, as a household, it creates a structure that may result in a better long-term outcome.
If married, age differences also come into play. What if one half is ten years younger? It may make sense for the younger partner to have a more aggressive allocation, as it is the older of the two who will be the first to have to start taking required distributions.
Whether single or married when you look at your investments at a household level, you can make choices that can lower the overall fees you pay, better align the investments to a specific outcome, and you can take advantage of options that may be available inside of one account but not in another.
The last thing to talk about regarding 401(k)s is what to do when you leave your employer? Do you leave the funds there, or roll them to an IRA account or to a new plan?
Most of the time, I think moving the funds is the best choice; however, first, let’s talk about three situations where moving the funds may NOT be the right thing to do.
First, as we already discussed, if you leave your employer after you turned age 55 but before age 59½, if you move your 401(k) plan before age 59½ this will void your ability to access funds penalty-free. If you won’t need the money during that time, this won’t be relevant. But if there’s a chance you might need to take withdrawals, you may want to wait until age 59½ before you proceed with the rollover.
Second, if your 401(k) plan offers a unique fixed income or guaranteed account option, that might warrant keeping funds in the plan. For example, some plans offer something called a guaranteed insurance contract (GIC) that pays an attractive fixed rate of return. Other plans, such as the options in the public education system through TIAA-CREF, offer a fixed account that usually pays a competitive rate. Some 401(k) plans offer stable value funds. All of these investment options are not easily replicated outside of the plan.
If your plan offers these types of options, think twice before you roll it over.
Third, don’t move funds out of an old 401(k) if you don’t know where to move the funds and don’t feel capable of making this decision right now. For example, maybe your 401(k) plan had something called a target date fund. The “target date” is a calendar year, and you pick a fund with a year that is closest to the year you think you might retire. So, if you will reach age 65 in the year 2035, you would pick a Target Date fund with the year closest to 2035.
This type of fund automatically invests for you and makes changes to the investments as you get closer to the target year. For those who don’t know what else to do, I think these can be GREAT choices. So, if you don’t want to go through the process of finding a financial planner, and don’t want to do your own research, leaving the funds in a place where they can easily remain invested in a Target Date fund can be better than trying to guess about picking new investments - and it is much better than making a rushed decision and hiring the wrong kind of person to help.
What if none of these three situations apply to you? Then my view is that rolling the old 401(k) to an IRA or to a new plan makes sense.
First, it is a lot easier to keep track of. When it comes to address changes and beneficiary changes, you now have one less place where you have to do paperwork.
Second, it is much easier to invest. When your accounts are scattered across old plans, next thing you know you get a notice from one plan or another that they are changing the 401(k) provider, or switching out one fund option for another. Each time this happens you have to realign your investment allocation. When you consolidate accounts, this process is easier to manage.
Third, in an IRA, you have choices that are not available inside 401(k) plans, such as CDs and individual bonds. If you are building a customized portfolio designed to help your money last as long as possible, having this broader set of choices may help you build a better plan. And now, you are in control of the investments – so if your employer changes fund companies it won’t impact you.
One thing to watch out for with rollovers - from the time the funds leave one plan, they must be deposited to another qualified account within a 60-day time frame. The paperwork must be done right to avoid the taxes – so take your time and read the fine print when doing rollovers or transfers.
We’ve now touched on the basics of 401(k) plans. We’ve talked about the creditor protection rules that apply to 401(k)s, the age related rules, what to think about when choosing investments, and we’ve looked at how rollovers work and when it does and does not make sense to do them.
Thank you for taking the time to listen today. The printed version of Chapter 7 of Control Your Retirement Destiny has additional content that covers numerous types of stock option plans and deferred compensation plans as wells a pension plans.
Visit amazon.com to get a copy in either electronic or hard copy format.
You can also visit sensiblemoney.com, to see how a staff of expert retirement planners can help.