Withdrawing From A 401(k)

Loans

\0xA0 Loans may be allowed within a 401(k) plan.\0xA0 However, the employers are not mandated to allow them.\0xA0 Most financial planners advise against withdrawing money from a 401(k) plan for any reason other than retirement.\0xA0 Financial planners realize the dangers of being under-funded in retirement.\0xA0 Having said that, there will still be times when participants wish to make 401(k) loans.

Can I Borrow From My 401(k)?

\0xA0 For those who feel they absolutely must withdraw funds from their 401(k) plan, they must first know if their 401(k) even allows loans.\0xA0 The summary plan description (SPD) should be able to tell the participant if the plan allows for \0x201Chardship\0x201D loans.\0xA0 The easier option may be to go to the company\0x2019s benefits department and ask them.\0xA0 If an employer allows loans, there is a lot of paper work that goes with the loan process, not to mention the extra costs to add a loan feature to a 401(k) plan.\0xA0 If an employer does allow loans, they may put restrictions on the loans.\0xA0 Remember, the 401(k) was set up for retirement, nothing else.\0xA0 By making such loans difficult, the employer may be considering the best interests of their employees.

"It's my money I'm borrowing - right?."

\0xA0 Sometimes an employer NEEDS to add the loan feature to their 401(k) plan.\0xA0 This may be especially true for the lower paid employees who may want accessibility to their funds.\0xA0 The highly compensated employees (HCEs) in a plan are limited to how much of their salary they can contribute by the amount of dollars the non-highly compensated employees contribute.\0xA0 By adding the loan feature, this may attract more participation.

\0xA0 The next step when withdrawing money from a 401(k) is to ask for a copy of the plan\0x2019s loan program.\0xA0 This may not have been included in the packet the company gave the employee when they signed on.\0xA0 The loan packet needs to be read completely because withdrawing money from a 401(k) plan enters the employee into a legal and binding agreement with the plan trustee.

What Reasons Allow A Withdrawal?

\0xA0 According to the IRS code, a plan may provide for hardship withdrawals only if both of the below are met:

\0xA0 For a plan to determine if the participant is qualified for a hardship loan they can use the facts and circumstances test or the safe harbors provided in the IRS regulations on plan distributions.\0xA0 IRS does give some guidelines, but they can be hazy.

\0xA0 Next the employer must decide whether the hardship withdrawal is necessary to satisfy the employee\0x2019s immediate and heavy financial need.\0xA0 The test is passed if the withdrawal does not exceed the amount required to relieve the financial need (basically if a person needed $10,000 & their 401(k) had only $7,000 this would not relieve the financial burden completely), and the need cannot be satisfied from other resources that could be available to the employee.\0xA0 Resources are defined for this purpose as all of one\0x2019s resources - including what a spouse owns and their minor children.\0xA0 The exception regarding the children are those assets held in a Uniform Gift to Minors Act account.

\0xA0 If the person is under age 59 \0xBD, they may be allowed a \0x201Chardship\0x201D withdrawal (and may not be required to pay it back) which means they can take money from their 401(k) plan only for one of the following:

\0xA0 The above is basically the safe harbor test.\0xA0 The safe harbor test is more restrictive than the facts and circumstances test.\0xA0 For employers, the safe harbor test is easier because they do not have to make judgment calls in determining whether the employee has a real need.\0xA0 The safe harbor test also protects the employer since the employer will not face an IRS audit and challenge if all the hardship distributions are limited to those specified in the IRS code.\0xA0

\0xA0 If an employee/participant qualifies with one of the above and they decide to get the withdrawal, they must meet four additional requirements, which are:

  1. The withdrawal must not exceed the amount needed by the employee.\0xA0 No person may borrow more than they actually need.

  2. The employee must have obtained all distributions or nontaxable loans available under all plans of the employer.\0xA0 This means the participant must have already exhausted all other financial sources before withdrawing (borrowing) from their 401(k) plan

  3. The employee\0x2019s maximum elective contribution in the next taxable year must be reduced by the amount of the hardship withdrawal.\0xA0 This means that the participant may be limited in the contributions they can put into their 401(k) account while the loan is outstanding.

  4. The employee must be prohibited from making elective contributions to the plan for 12 months after the withdrawal.\0xA0 This means that a participant cannot contribute to their plan for one year.

\0xA0 These guidelines are not sure bets, but most 401(k) plans do have these in them.\0xA0 One main reason is it\0x2019s easier than trying to set up their own guidelines and trying to please everyone.\0xA0 The \0x201Chardship\0x201D withdrawals are still subject to a ten percent IRS penalty along with ordinary income taxes.\0xA0 A person must also show that they have no other source of money to borrow from to qualify for the hardship loan.\0xA0 Some plans will limit what the participant can borrow.\0xA0 For instance, the 401(k) may not allow the participant to withdraw any of the interest earned or any employer contributions.\0xA0 The participant can only borrow what they themselves have deposited.

\0xA0 Other situations that allow a person to withdraw from a 401(k) plan and avoid the 10 percent IRS penalty are:

\0xA0 No matter what, the plan must set up uniform and nondiscriminatory standards for hardship withdrawals.\0xA0 The rules must apply to everyone, and not favor any one group.

Qualifying For a Hardship Loan . . .

\0xA0 So, the employee has qualified for a hardship loan.\0xA0 They may find that\0x2019s the easy part. \0xA0The participant will be liable for taxes and, if the participant is not at least age 59 \0xBD, they will also be liable for a ten percent penalty.\0xA0 Then, if the participant is in the 28% federal tax bracket and is liable for state taxes and under the age of 59 \0xBD, they may also owe over 40% of their withdrawal in taxes and penalties.\0xA0 Ouch!

How Much Can Be Borrowed?

\0xA0 The Internal Revenue Code section 72(p) sets aggregate loan limits.\0xA0 If these loan limits are not followed, the loan will be treated as a taxable distribution and possibly be required to pay the ten percent IRA penalty.

\0xA0 Outstanding loan balances to a participant or their beneficiary cannot exceed the lesser of either:

\0xA0OR

\0xA0\0xA0A loan of up to $10,000 can still be made, even if the total ends up being more than half of the participant\0x2019s vested account balance, as long as it fulfills the first condition.

\0xA0 Any loan made must be repaid back to the 401(k) within five years, unless the proceeds are used to acquire a principal residence (not a second home) for themselves or their surviving spouse.\0xA0 The interest on the loan is paid back to the 401(k) itself, essentially to themselves.\0xA0 Interest on these loans is not deductible unless the loan is collateralized by a home mortgage.\0xA0 Even if a home mortgage is used to secure the loan, interest paid is not deductible if the borrower is a key employee or if the 401(k) plan is based on salary reductions.

On a 401(k) loan a person pays income tax when they borrow funds and again when they withdraw funds in retirement.

\0xA0 If the business is not incorporated, loans to an employer or anyone who owns more than ten percent of the company are not allowed.\0xA0 If the business is an S-Corporation, any employee who owns more than five percent of the business is also not allowed to borrow from their 401(k).

How does a person borrow from their 401(k)?

\0xA0 Some company plans can be very easy to borrow from.\0xA0 All a person has to do is walk into the benefits department and verbally request the loan.\0xA0 Other company plans will want the person to fill out a formal application.\0xA0 If loans are available in a 401(k) plan, they generally are easy to obtain because no credit check is necessary.\0xA0 If the money is there, they will usually loan it to the participant unless they need a spousal consent.

\0xA0 Many turn to their 401(k) because all other sources have been exhausted due to bad credit or no available collateral.\0xA0 An advantage to a 401(k) is accessibility.\0xA0\0xA0 A participant can usually get their money pretty quickly, which may be necessary if there is a financial emergency.

\0xA0 Once the loan has been approved, there is paperwork to be signed.\0xA0 A person will probably have to sign a promissory note promising to pay back the loan over a stated period.\0xA0 The loan papers will state the dollar amount that will be deducted from their paycheck each week, the interest rate charged, and the number of payments required.\0xA0 Depending on the plan, there may be more paperwork.\0xA0 All paperwork needs to be read carefully.

\0xA0 Once the participant leaves the company, loans may no longer be available from their 401(k) plan if they decided to leave the money with their previous employer.

How much will it cost a person to withdraw from their (401) plan?

\0xA0 Some companies charge a service fee to process and service the loan.\0xA0 These fees are the same types of fees a person would have if they had gone to their bank.\0xA0 These fees could add up to as much as $200 over the life of the loan.\0xA0 All this just to borrow one\0x2019s own money - a one-time processing fee and then the annual service fees.

\0xA0 There will also be an interest rate that must be paid.\0xA0 Plans must charge the current market rate, equivalent to what a person would be charged at a local bank.\0xA0 The interest rate is usually one or two percentage points above the prime rate.

\0xA0 Generally most companies make it easy for a person to pay back their 401(k) by making payroll deductions.\0xA0 However, if the company does not, the employee will be required to make at least quarterly payments to the plan trustee.\0xA0 The interest that the person is paying will go right into the 401(k) account along with the amount they are paying back each paycheck.

What is the 10% Penalty & how can it be avoided?

\0xA0 Taxes are a part of life in the United States.\0xA0 However, as already discussed, there are some circumstances where the ten percent penalty may be avoided.\0xA0 The contributions were deposited on a pretax basis, so when funds are withdrawn taxes will be due.\0xA0 Although there could also be a ten percent penalty, it might be waived in the following circumstances:

What if a person cannot pay back the loan?

\0xA0 Loans must be paid back within five years, except for the purchase of a primary residence.\0xA0 In this case, a person may have 10 to 25 years to pay off the loan, depending on the generosity of the plan.

\0xA0 If an employee has lost their job because of downsizing or they quit and they have an outstanding loan, in most cases, they have to pay it back immediately.\0xA0 If a person cannot do this, the outstanding loan is considered a premature withdrawal and they\0x2019ll owe taxes on the outstanding amount left on the loan.\0xA0 And if they are under 59 \0xBD, they will owe a ten percent IRS tax penalty.\0xA0 One danger of borrowing from a 401(k) plan is this possibility of being required to repay the loan immediately.\0xA0 If the participant has no way of paying back the loan, they may need to withdraw even more money from the plan to pay off the taxes and penalty due.

\0xA0 With most other types of loans, there is some sort of collateral that the lender can attach if the borrower defaults on the loan.\0xA0 What does the 401(k) do?\0xA0 They send a 1099R form to both the borrower and the IRS stating that a distribution was taken from the retirement plan.\0xA0 Both the loan amount and income taxes will be due for that year.\0xA0 In addition the ten percent tax penalty will be due if the participant is under age 59 \0xBD.

How much does the loan REALLY cost?

\0xA0 When a person borrows from their 401(k) account, there is an opportunity cost associated with the loan.\0xA0 Even though the participant must repay the loan, the dollars initially contributed to the plan went in the 401(k) on a pretax basis.\0xA0 When the loan is repaid, however, it is repaid with dollars that have already been taxed.\0xA0 Therefore, when the retirement plan is eventually used, part of the money will be taxed twice: (1) the amount of the loan repayment was taxed, and (2) that portion will be taxed a second time as it is withdrawn for retirement. Even though the repayment amount was paid back with taxed dollars, those taxed dollars are not recognized.\0xA0 As far as the IRS is concerned, the account still holds totally untaxed deposits.

\0xA0To restate this:

\0xA0 When the participant retires and begins to withdraw from their account, they will be required to pay income tax on all of their withdrawals, even if part of the account had already been taxed due to a loan repayment. This is called double taxation.

\0xA0 There is another consideration to the real cost of the loan:\0xA0 how it affects the overall growth of the plan.\0xA0 By taking money out, there are fewer funds to grow.\0xA0 If the participant does not contribute to their 401(k) while the loan is being repaid, this can further deplete a 401(k)\0x2019s overall effectiveness.

Taking money from your 401(k)

-Rollovers &\0xA0Transfers

\0xA0 Participants are generally eligible to roll over 401(k) money if:

\0xA0 Participants cannot roll all the payments from a 401(k) plan.\0xA0 Some money can and cannot be rolled over or transferred.\0xA0 The following list can be rolled over:

\0xA0 Not all funds may be rolled over or transferred. The following list cannot be rolled over:

\0xA0 Let\0x2019s say the participant finds a better job with better benefits.\0xA0 What do you do with the money in the current 401(k) plan?\0xA0 The first step is to go to the benefits department and find out what options are available.\0xA0 The participant may be able to leave the money right where it is if they have $5,000 or more in the plan. If the account is over $200, the plan sponsor must offer the chance to do a trustee-to-trustee transfer (avoiding the 20 percent rule).\0xA0 This is often used until the participant can figure out where to put the funds when they are withdrawn.\0xA0 The former employer cannot kick a participant out the 401(k) plan, but they will not allow them to make new contributions or loans.\0xA0 It may be that the investment is doing quite well in the 401(k).\0xA0 If a participant can leave the money in the 401(k) it still should periodically be checked to make sure the investment is meeting their expectations.

\0xA0 The easiest solution when leaving a company is transfer to another 401(k) plan.\0xA0 Not all companies have such plans, so this is only an option when the new employer does have a 401(k) for their employees.\0xA0 The new company, if a 401(k) plan does exist, will give the employee the same general packet of information that was received at the former company, although there may be plan design differences.

Can a partial amount be transferred into the new 401(k) plan?

\0xA0 Again, the employee needs to check with the employer.\0xA0 Though most employers will not let a person take a partial distribution of their money.\0xA0 They either need to take all their money or leave it where it is.

Transferring ...

... Old To New

\0xA0 If the new company does offer a 401(k) and does allow direct transfers, then the employee just needs to see if there is a waiting period before the funds can be transferred.\0xA0 Some employers will accept rollovers from another employer, but NOT accept transfers.\0xA0 If the new plan is very easy to work with, all the participant has to do is fill out some forms, contact the old plan and have the money transferred to the new plan.\0xA0 When the transfer takes place, the check should not go to the participant or be made out to the participant.\0xA0 The transfer should take place between the two trustees.\0xA0 This would not be considered a distribution so there are no penalties or taxes to be paid or withheld.

Transferring ...

... To An IRA

\0xA0 The easiest way to avoid a tax consequence is to transfer the money directly into the 401(k) or 403(b) plan of the new employer.\0xA0 However, if the participant decides that the new plan\0x2019s investment options aren\0x2019t that great, they have the option of transferring the money into an IRA.\0xA0 When transferring money from a 401(k) to an IRA, there are no limits are the amount a person can transfer.\0xA0 There is also no limit to the number of transfers that a person can make within any one year.

\0xA0 Again, no matter what decision is made, the participant should communicate this decision in writing to the administrator of the former employer\0x2019s plan.\0xA0 An application must be filled out from the company chosen to handle the IRA and sent back to them.\0xA0 They, in turn, will send paperwork off to the former employer\0x2019s plan.\0xA0 Since mistakes do happen and the check comes to the participant, make sure it is made out to the new trustee.\0xA0 As long as it is made out to the new trustee or custodian, it is still considered a transfer, not a rollover.

\0xA0 A transfer from a 401(k) to an IRA is called a conduit IRA.\0xA0 As long as the participant keeps this IRA separated from all the other IRAs they may own and does not add any new contributions to it, they will reserve the right to roll it back into a 401(k) plan in the future. \0xA0This IRA cannot and should not be commingled - no other money should be included in this IRA.\0xA0 This is especially true if there is a waiting period in the new company\0x2019s 401(k) plan.\0xA0 If the participant transfers the money into an existing IRA account, the funds will be commingled and thus lose the ability to transfer them to any 401(k) in the future.

For Example:

\0xA0 Let\0x2019s say that the employee left one company to work for another.\0xA0 The employee completes the paperwork for a transfer of their 401(k) to the new company\0x2019s 401(k).\0xA0 One month later their former employer sends them a check made out in the employee\0x2019s name.\0xA0 What should they do?

  1. Endorse the check (not paying attention to the amount) and send it to their new custodian or employer.\0xA0

\0xA0OR

  1. Send it back to their former employer with a copy of the letter of instruction, directing them to issue another check made out to their new custodian without withholding 20 percent.

\0xA0 Such a payment for transfer should never be made out to the participant.\0xA0 It should always be made out to the new custodian or trustee.

What is the Difference Between a Rollover & a Transfer?

\0xA0 We\0x2019ve already spoken of trying to do a transfer instead of a rollover.\0xA0 Here\0x2019s why: in January 1993 a federal income tax law was passed to regulate rollovers.\0xA0 It requires that employers who make 401(k) or 403(b) distributions to employees withhold 20 percent of the value of the account and remit it to the IRS as a potential tax payment.

\0xA0 Another drawback of a rollover is that the employee has to come up with the 20 percent from other sources to avoid a tax consequence when IRS is the one holding it.\0xA0 For instance: a person has $100,000 (full value) in a 401(k) plan.\0xA0 They choose to roll it over into an IRA.\0xA0 The company gives that person a check for $80,000 and sends the other $20,000 to the IRS.\0xA0 The employee has to roll the FULL VALUE of the account over into an IRA within 60 days from the date the person received the distribution to avoid tax consequences.\0xA0 That means the person has to come up with the other $20,000 (that was sent to the IRS) from other sources.\0xA0

\0xA0 IRS will give back that $20,000 at the end of the tax year in question when that person files for a refund.\0xA0 If the FULL VALUE of the account is rolled over into the IRA within the 60 day time requirement, the participant is not responsible for current income taxes or any penalty if they are under age 59 \0xBD.\0xA0 If the other 20 percent is missing, it will be taxed and penalized as an early distribution.

\0xA0 Let\0x2019s say the participant changes their mind and wants the money back into a protective shell.\0xA0 That person still has to come up with the 20 percent until they file their tax return.\0xA0 The down side for the person and the up side for the government is that for a year (or however long), the participant loaned the government $20,000 interest-free.

\0xA0 To avoid what could be a huge headache, it has been recommended to favor transfers over rollovers (also termed direct rollovers) whenever possible.

Temporary Transfer

\0xA0 When a change is desirable, the participant may want to transfer to an IRA temporarily.\0xA0 A transfer into the new plan may be delayed.\0xA0 This will allow the participant to avoid the 20 percent withholding, as it does not apply to rollovers that come from IRAs, only those that come from the employer plans.

\0xA0 It has been recommended by the National Center for Financial Education that the distribution be transferred into a government securities money market fund, a safe investment, until a place can be found for permanent deposit.\0xA0 The money would still be enjoying tax-deferred status.\0xA0 Remember, a transfer happens between two entities and the \0x201Cowner\0x201D of the money never has direct possession of the funds.\0xA0 In a rollover, the owner becomes the middleman between the two.

What happens when a Divorce Happens?

\0xA0 A Qualified Domestic Relations Order (QDRO) is an order of the court pursuant to state domestic relations law involving marital property rights, child support or alimony to a spouse, former spouse or dependent of a plan participant.\0xA0 Once a QDRO has been issued it requires the husband\0x2019s retirement plan to give the wife (the non-covered spouse) a legal interest in the retirement plan.\0xA0 The court directs the husband\0x2019s employer to set up a separate account for the wife.\0xA0 Neither can have more rights to the retirement plan than the other.\0xA0 The QDRO is established after reviewing the assets that need to be divided.

\0xA0 Funds from the QDRO can be transferred over into an IRA.\0xA0 The same tax consequences would apply as previously stated for rollovers and transfers.\0xA0 If the QDRO is set up for children or dependents, they cannot roll over the funds into an IRA.\0xA0 This is reserved for spouses only.\0xA0 If the child or dependents take out a lump sum, taxes will be due and the owner of the 401(k) account pays for those taxes.

\0xA0 In community property states such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin, the retirement account becomes part of the marital assets to be divided evenly.\0xA0 The funds can be used for child support or alimony.\0xA0 The courts can assign the rights to receive all or a portion of the plan benefits to a former spouse, child or dependents.\0xA0 A QDRO cannot be stopped.\0xA0 The courts go directly to the plan trustees.

\0xA0 Once a QDRO is established it will take precedence over any other required payment except for previously filed QDROs, regardless of the dates of the marriage.\0xA0 If the spouse has been married before and has an existing QDRO in place applying to their retirement plan, the earlier QDRO must be paid and any benefits received from the second QDRO are based only on the benefits left over after the first QDRO is satisfied.

\0xA0 By law the Qualified Domestic Relations Order must contain the following:

  1. The name and last known mailing address of the plan participant (the former spouse).

  2. The name and address of all alternate payees - the spouse or children.

  3. The amount or percentage of the participant\0x2019s benefit to be paid to each alternative payee or the method to be used by the plan administrator to determine the amount to be paid to the alternative payees.

  4. The number of payments or the period of time the QDRO covers.

  5. The name of each plan covered by the QDRO.

\0xA0 Some retirement plans provide a model QDRO, which they accept and may even supply.\0xA0 The model QDRO should only be used as a guide.\0xA0 The model that they provided was designed to be in the best interests of the plan, not the best interests of the nonparticipating spouse.

\0xA0 Before drafting and submitting a QDRO to the courts, it may be wise to choose an attorney well versed in QDROs and it may also be advantageous to contact the plan administrator for any unusual provisions in the plan or the most common errors.\0xA0 The retirement plan administrator can reject a QDRO if it is not well written in terms of the payment language.\0xA0 In fact, according to surveys, over 70% of plan administrators find handling QDROs difficult and time consuming.\0xA0 The survey further stated that 80% of plan administrators find the language regarding the amount to be paid to the spouse to be unclear or uncertain.

\0xA0 Obviously, the QDRO should first of all get the name of the plan correct.\0xA0 This may seem like an easy enough task, but if the plan administrator accepted the QDRO with an incorrect name, they would be violating ERISA and their fiduciary duties.\0xA0 For instance, the QDRO comes to the plan administrator with the name ABC Retirement Protection Plan.\0xA0 However, the name of the plan is actually ABC Retirement Income Plan. These may seem correct enough to the layperson, but the plan administrator cannot accept any document that is not absolutely correct.

\0xA0 Once the QDRO has been issued the nonparticipating spouse becomes a participant.\0xA0 Therefore, the QDRO cannot require the plan to give them any form of benefit or use any type of payment option, which is ordinarily not available to any other participant under the plan.

\0xA0 The QDRO must spell out what happens if the original participating spouse dies before they are eligible to receive their retirement benefits and what happens when the original participant dies after retirement.\0xA0 The QDRO should plainly state exactly what dollar or percentage benefit the newly participating spouse is to receive.\0xA0 This might be a dollar sum, a percentage of the benefit, or a combination of both.

\0xA0 Once the plan administrator receives and accepts the QDRO it becomes effective.\0xA0 The plan administrator then has a \0x201Creasonable period\0x201D of time to decide whether the QDRO is qualified.\0xA0 Although the law does not specifically define the \0x201Creasonable period\0x201D most professionals give an administrator 90 days to review and rule on the QDRO.\0xA0 The plan administrator can withhold benefits up to 18 months while it decides on the validity of the order.\0xA0 However, this delay is only an issue if the newly appointed QDRO participant is entitled to benefits immediately.

\0xA0\0xA0The Retirement Equity Act (REA) strictly limits domestic relations rights to state court orders meeting the statutory requirements for qualified domestic relation orders (QDROs).

Withdrawals ...

... Disability

\0xA0 For a person to get funds due to a disability, they must be retired as a result of a permanent or total disability to avoid the IRS ten percent penalty if under the age of 59 \0xBD.\0xA0 According to the IRS, a person must meet a special definition of disability by virtue of being unable to \0x201Cengage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can be expected to result in death or to be a long continued and indefinite duration.\0x201D

Withdrawals ...

... Section 72(t)

\0xA0 Section 72(t) allows periodic distribution based upon IRS approved calculations.\0xA0 All IRA and 403(b) account owners are eligible at any time for any reason.\0xA0 However, participants in a 401(k) plan are eligible only after separation from the company they work for - either by quitting, being laid off or being fired.\0xA0 This should only be considered if the participant has a large account since payments are based on their life expectancy.\0xA0 So if the participant is in his or her 40\0x2019s, the payments could be quite small.\0xA0 In addition, had they left the funds in the retirement account, their money would be compounding.\0xA0 If the participant leaves their money in their account for another 20 years, that\0x2019s 20 more years of principal and interest earning interest - compounding.

\0xA0 Once Section 72(t) distributions have been started, it is locked in and must continue for five years or until the participant reaches age 59 \0xBD, whichever is longer.

\0xA0 If the payments are modified for any reason other than a disability or death before the above criteria has been met, the IRS will impose that ten percent penalty plus interest and it is retro active.

\0xA0 Section 72(t) may be a good idea for someone in their 50s who is out of work and looking for another job.\0xA0 Upon reaching either age 59 \0xBD or five years they can stop the payments until they reach age 70 \0xBD, when mandatory distributions begin.

Withdrawals ...

... Retirement

Retire at age 55

\0xA0 If a person decides to retire at age 55 there is no ten percent penalty imposed.\0xA0 The ten percent penalty does not apply to distributions made to an employee after being fired or quitting and with an attained age of 55.\0xA0 The person must have worked their 55th year.\0xA0 They cannot retire at age 52 and in three years start distributions from the plan and hope to use this method of distributions to avoid the penalty.

\0xA0 If a person does plan to retire early (before age 59 \0xBD) and they have planned well enough to do so, they should not have plunked all of their retirement funds into qualified, tax-deferred accounts, such as 401(k) plans or IRAs.\0xA0 They would want to invest some of the retirement funds outside these accounts so that they do not incur penalties when withdrawing before age 59 \0xBD.

Retire at age 59 \0xBD

\0xA0 Social security hasn\0x2019t started yet (it will at either age 62 or 65), but the person wants to retire.\0xA0 The individual has planned well enough that they have the funds from their retirement accounts to enjoy their retirement.\0xA0 They have also reduced their debt in credit cards and other spending so that their retirement funds will not be used to pay off bills acquired ten years ago.\0xA0 The individual has decided to move to Montana where they feel the cost of living is cheaper than California.

\0xA0 Having made these decisions regarding their style of living in retirement, other financial decisions must now be faced.

Can I leave my money in my qualified plan?

\0xA0 The participant could decide to leave their funds in their 401(k) plan.\0xA0 It does make sense if the participant is happy with the investment choices and with the mutual fund company that manages the funds.\0xA0 Once the participant decides to retire, it is not mandatory that they begin to withdraw funds or transfer their money.\0xA0 The participant does not have to start withdrawing from their 401(k) until they reach age 70 \0xBD.

How does the participant want their money?

\0xA0 Generally retirement plans offer several ways for a person to take the balance of their plan account at retirement.\0xA0 Some of the options are:

\0xA0 Taking a lump sum payment does trigger a large tax liability.\0xA0 If the participant does take a lump-sum payment, the IRS allows some persons to pay the tax as if they had spread out the distribution over a five or ten year period.\0xA0\0xA0 Five year averaging was only available through 1999.\0xA0 Ten year averaging is only available to employees who were born before 01/01/1936.\0xA0 The distributions must qualify as a lump-sum distribution, meaning that it included all money from all plans received after age 59 \0xBD and that they had participated in the 401(k) plan for five or more taxable year before the distribution.

\0xA0 When receiving installments, the participant is not taxed until the money is actually received.\0xA0 The money that remains in the annuity still enjoys the tax shelter until the money is distributed.

\0xA0 If someone is looking for the best way to use their money from their 401(k), there are no clear-cut answers.\0xA0 With regard to lump-sum distributions or installments, no one knows how long the participant is going to live or the number of years their spouse will survive them.\0xA0 No one can predict with certainty how the investment portfolio will perform.

Minimum Distributions

\0xA0 A person must begin minimum distributions by April 1st following the year in which they reach age 70 \0xBD. The IRS will determine the minimum amount a person needs to withdraw, based on life expectancy tables.\0xA0 From a taxable standpoint, the IRS would rather a person take out large sums of money.

\0xA0 There are two methods that can be used to calculate minimum distributions the:

  1. term-certain method and

  2. recalculation method.

\0xA0 The term-certain method is the simplest. The value of the account, as of December 31st of the year before distributions must begin, divided by the account dollars by the person\0x2019s life expectancy or the combined life expectancy of the owner and beneficiary.

\0xA0 In order to determine the amount that is required to withdraw, the IRS\0x2019s Expectancy Table will need to be obtained.\0xA0

\0xA0 The recalculation method requires a little more math.\0xA0 The participant is basically using the same IRS Survivor Expectancy Table, but since people grow older each year, it must be \0x201Crecalculated\0x201D using the formula for the term-certain method.\0xA0 Although there is not a lot of difference after just one year, the sum will continually grow smaller.\0xA0 As the participant continues using the recalculation method, smaller and smaller amounts will be taken out prolonging the payout schedule.

Withdrawals ...

... Death

\0xA0 If the participant dies before retirement, their beneficiary is entitled to their 401(k) account balance.\0xA0 There will be no ten percent penalty, but they would be responsible for ordinary income tax.\0xA0 The beneficiary may have the choice between a lump-sum distribution and an annuity.\0xA0 If the beneficiary is a surviving spouse, then they have the option of transferring the funds into an IRA.

\0xA0 If the beneficiary chosen is someone other than the spouse, then spousal consent is required for the beneficiary designation before the employee dies.\0xA0 The spouse must agree with this in writing.\0xA0 The consent form must be notarized or witnessed by a plan representative.\0xA0 The form should specifically state what the agreement is.\0xA0 If the form is a \0x201Cgeneral\0x201D consent form, then the participant is permitted to change the beneficiary without again obtaining spousal permission.

Withdrawals ...

... Company Stock

\0xA0 When the participant leaves or retires from the company, they do not have to sell the company stock in their 401(k) plan.\0xA0 If the participant is well diversified in their retirement portfolio and believes their company stock is good, the participant may want to consider taking the stock as a distribution (keep it).\0xA0 Again, someone who is considering taking the stock as a distribution should not be over-exposed to the market\0x2019s volatility.\0xA0 Company stock can rise and fall.\0xA0 We have seen this even with some very well known companies.\0xA0 IBM\0x2019s stock was very high and then dropped.\0xA0 Amazon.com\0x2019s stock was high at one time, but then took a drop in value.\0xA0 Of course, it is the nature of stocks to rise and fall, which is why diversification is so important.

\0xA0 If the participant is not retiring and still considers the stock a good investment, they could consider transferring it to a self-directed IRA.\0xA0 Self-directed IRAs are an exception to the 20 percent withholding rule.\0xA0 Distributions that consist entirely of employer contributions of the employer\0x2019s company stock are excluded from the withholding.\0xA0 In this instance it is as convenient to do a rollover as it is a transfer.

\0xA0 If the company only offers company stocks as a distribution, the participant will have trouble finding a way to roll them over.\0xA0 Most new 401(k) trustees and financial institutions will not accept company stock.\0xA0 However, some brokerage firms will take a participant\0x2019s rolled over shares.

Excess Distributions

\0xA0 The IRS imposes a 15 percent penalty tax if the participant takes too much money out of their 401(k) no matter what the circumstances are.\0xA0 If the total distributions exceed $144,551 for a calendar year, the 15 percent penalty will apply.\0xA0 The \0x201Ctotal distributions\0x201D are calculated from all qualified plans including, but not limited to, IRAs, Keoghs and 401(k)\0x2019s.

\0xA0 If the plan participant elects to receive a lump sum distribution the dollar limit increases five fold to $722,755 (inflation indexed) or $750,000 - which is greater.

Survivorship Issues

\0xA0 We\0x2019ve already discussed spousal consent if the 401(k) plan (a type of profit-sharing plan) beneficiary is not a spouse.\0xA0 When the beneficiary is not the surviving spouse, the beneficiary must be given the choice of selecting one of the two following death benefits:

  1. a qualified pre-retirement survivor annuity, or

  2. a qualified joint-and-survivor annuity.

\0xA0 The qualified pre-retirement survivor annuity is an annuity for the life of the surviving spouse.\0xA0 It must equal at least 50 percent of the employee\0x2019s vested account balance as of the date of death.\0xA0 If no election has been made, this is the choice made for them.\0xA0 If the 401(k) permits it, the participant can opt for some other form of spousal benefit including no pre-retirement survivorship benefit at all or benefits payable to someone other than a spouse.\0xA0 No matter what is selected, the spouse must consent in writing to the waiver.

A Review

True or False
 Loans are allowed within a 401(k). However, the employers are not mandated to allow them.
True or False
 For the plan to determine if the participant is qualified for a hardship loan they must use the facts and circumstances test and the safe harbors provided in the IRS regulations on plan distributions.
True or False
 Any loan made must be repaid back to the 401(k) within five years, unless the proceeds are used to acquire a principal residence (not a second home) or for their surviving spouse.
True or False
 A person must begin minimum distributions from their 401(k) by April 1st following the year in which they reach age 70 \0xBD.
True or False
 The Internal Revenue Code section 72(p) does not set aggregate loan limits.

End of Chapter 7

United Insurance Educators, Inc.