What are your options with your 401k lump sum or pension?

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When contemplating taking a payout from an employer-sponsored plan, you have to first determine what you have. Is it a defined contribution plan, such as a 401(k), 403(b) or 457(b) plan? Or is it instead a defined benefit plan, such as a pension or a cash balance plan?

The type of plan you have (some people are fortunate enough to have both) and rules (both IRS and your employer) will dictate your options in terms of being able to take money out before and after you retire. These will also determine under what circumstances and when you can do so, as well as the consequences that might be incurred.

To gain a complete understanding of options and what is and isn’t allowed specific to your plan, it’s advised you consult with your company’s plan administrator prior to making any decision.

It’s also a good idea to consult with a retirement planner or investment advisor so they can answer all questions (including helping you determine if you are ready for retirement) and help guide you in your overall retirement planning, given the importance of your savings in your golden years.

Defined Contribution Plans

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When it comes to defined contribution plans, such as 401(k), 403(b), and 457(b), the IRS allows certain types of distributions or loans to the account holder or rollovers to a different plan.

These can be dependent on key considerations and circumstances, ranging from pre-retirement or post-retirement, age, the reason for distribution, how it is managed, and more.

Pre-Retirement Guardrails

There are several key considerations when taking lump sum distribution pre-retirement, some of which can be quite painful. That’s because the government wants to place restrictions (think of them as guardrails) that will keep people disciplined and hopefully at least partially funded for their retirement.

Major component of the guardrail system include strict restriction and an early withdrawal penalty of !0% for accessing 401k funds prior to the account owner turning age 59 1/2, with few exceptions.

Combined, these limitations and penalty are designed to deter you from drawing from your piggy bank and are meant to encourage you to look elsewhere before doing so.

Hardship Distributions

Word of Caution: Before continuing regarding hardship withdrawals and loans, it has to be made clear – we suggest you avoid them.

Paying taxes and potential penalties for pre-retirement withdrawals leads to reduced savings for retirement. Deviating from the discipline necessary to ensure you can meet your retirement dreams and goals is not a good habit and to be avoided if possible.

The IRS realizes “life happens,” so they have carved out exceptions for pre-retirement withdrawals. The most predominant is the hardship withdrawal.

Regarding hardship withdrawal allowances, the IRS requires that distributions must be due to events or circumstances that are both immediate and that create a heavy financial burden on an individual with an employer-sponsored retirement account, such as a 401(k). Additionally, the amount distributed must be limited to that which is needed to satisfy the financial need.

The question of whether an employer allows hardship withdrawals (and the types they allow) is a major issue that is entirely up to them.

Required Documentation

If they allow them, employers do have to define what participants can and can’t do in their plan document. You can ask your employer’s HR or go direct to the plan administrator for further info on their rules and allowances. They should also provide the list of the documents they need to verify the need for the distribution.

If you are able to take a hardship distribution from your employer-sponsored plan, the IRS has its own requirements regarding documentation that you’ll need to file in the tax year in which the hardship is taken.

Examples include things such as insurance or hospital bills, bank statements, school payments, invoices from a funeral home, escrow account documentation on the purchase of a home, and more.

What’s Allowed

The allowable hardships are defined as the following by the IRS: (Source: IRS Retirement Topic – Hardship Distributions)

  • Medical care expenses for the employee, the employee’s spouse, dependents, or beneficiary
  • Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
  • Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
  • Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
  • Certain expenses to repair damage to the employee’s principal residence.

Again, if the situation does arise, you will need to check with your employer or plan administrator to determine if one of these IRS-allowed hardships is actually allowable under your plan.

10% Penalty

Even if allowed, these withdrawals come with certain restrictions that you have to be aware of. You will have to pay income taxes on the previously tax-deferred contributions if you take a distribution.  And you may have to pay the 10% early withdrawal penalty if you are under age 59 1/2.

Examples of hardship distributions that incur the 10% early withdrawal penalty include the purchase of a principal residence, tuition and educational expenses, burial/funeral expenses, and for the prevention of foreclosure or eviction.

Hardships that don’t incur the penalty include medical expenses (if annual expenses exceed 7.5% of your AGI), separation of service, and permanent disability.

You can find a full list of what is penalized or not in the event of early distributions by reviewing IRS Topic No. 558 – Additional Tax on Early Distributions From Retirement Plans Other Than IRAs.

Read this article to learn more about accessing your savings before age 59 1/2 without penalty.

 

4 Key Hardship Considerations

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    • When you take a hardship distribution your retirement savings will be permanently reduced within that account at retirement
    • When you do take a hardship distribution from an employer, they will retain 20% to cover taxes due. If more is owed you will have to pay those taxes in the tax year in which the distribution was made
  • Hardship distributions cannot be repaid into your 401(k) account (you lose the tax-deferred benefit on the funds), but you are still eligible to continue contributing to the account going forward
  • Withdrawals are meant to meet the hardship issue and are not eligible for rollover into another plan, such as an IRA

Other Options

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Beyond hardship distributions, there are a number of pre-retirement exceptions and options available to you regarding your 401(k) funds that are worth noting.

SEPP Withdrawals

There is a type of withdrawal allowed prior to separation from your employer and age 59 1/2 where there is no penalty – SEPP payments (substantially equal periodic payments).

Once started you must continue until you reach age 59 1/2 or for five years, whichever is longer. And you must pay the income tax due for the funds distributed each year. If you quit taking the SEPP payments prematurely, you will owe all of the penalties avoided in the years previous, plus interest on those amounts.

We highly suggest working with a retirement planner before utilizing SEPP withdrawals. Calculation and timing withdrawal errors can end up costing you substantially.

Employment Separation

If you separate from your employer during pre-retirement years you have a number of options with your 401(k) or similar account, including:

  • Leave the account with your previous employer if they allow you to do so, but you will not be able to make additional contributions
  • Rollover to a new employer’s 401(k) plan if they have one and allow such contributions
  • Rollover pre-tax contributions to an IRA
  • Rollover after-tax contributions to a Roth IRA – After-tax contributions, also known as Roth 401(k) contributions, can be moved into a Roth IRA
  • Convert pre-tax contributions to a Roth IRA – you will have to pay income taxes on the distributed amount, but converted assets benefit from being treated according to the Roth IRA rules (tax-free)

Note: In the case of a rollover to a new employer plan or a traditional IRA, if allowed, this can be done as a direct rollover, in which case there is no 20% withholding by the previous employer to cover taxes for the distribution. This is the preferred method.

If instead you receive a check and deposit it with the new plan (indirect rollover), the previous employer will have withheld 20%, as required by the IRS. If you fail to deposit the entire redemption amount into the new plan within 60 days of distribution you will owe additional income taxes for any distributed amount that is not covered by the 20% withholding.

What is often neglected during indirect rollovers is that you must pay the 20% withholding out of pocket into the new plan. Otherwise, the withheld amount is viewed as a distribution from the plan and is subject to income taxes and penalties. If you are less than age 55 (see below) at the time of separation you will also owe the 10% penalty.

Rule of 55

You can take a distribution without incurring the 10% penalty if you are, or turn, 55 or older in the year you separate from your company. In this case, you can take the distribution and roll the funds into a qualified account (directly or indirectly), in which case your savings remain tax deferred. Accounts eligible could include the 401(k) of a new employer, an IRA, and others.

Or you can take the distribution and place it in a Roth IRA, pay the income tax due, but have no penalty and gain the benefit of tax-free savings.

In-Service Rollovers

You can elect an in-service rollover while still working with your employer if they allow this option. It allows you to take a portion of your 401(k) balance and roll into a traditional IRA account, in which case there is no penalty and the funds remain tax-deferred until they are eventually withdrawn.

401(k) Loans

If your plan offers loans, they can be taken for any reason but must be repaid within five years. The interest rate and payments are set by the plan and must be made at least quarterly. Payments are not considered a contribution, but you can continue to make contributions to your plan.

401(k) loan amounts are limited to the lesser of $50,000 in total or the greater of $10,000 or 50% of your vested account balance. The vesting schedules are based on your number of years employed and are set by your plan.

You can take out more than one loan against your plan at the same time, but the total combined cannot exceed the aforementioned IRS limits or those set by your employer.

Any amount not repaid within the five-year period of the loan is considered a distribution and incurs taxes and potential penalties. The IRS does allow for a suspension of loan repayment due to a leave of absence, but upon return you will still be required to pay the loan back to the account within the original 5-year period.

Any amount not paid in that period is treated as a distribution, incurring the aforementioned taxes and potential penalties.

Post-Retirement

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After retiring, you will have a number of options:

  • Leaving your 401(k) plan in place and taking taxable distributions as desired (required minimum distributions or RMDs are required starting at age 72)
  • Rollover to an IRA or an annuity. You can purchase an annuity directly or with funds from within the IRA – either way you can avail yourself of the lifetime income benefit of an annuity
  • Convert pre-tax contributions to a Roth IRA– you will have to pay income taxes on the distributed amount, but qualified distributions (regular Roth rules) thereafter will be tax and penalty free

Defined Benefits Plans

Lump Sum

When it comes to accessing money from your employer-sponsored defined benefit or pension plan, many don’t allow distribution for any reason prior to the retirement age they define in their plan documents, such as age 60 to 65.

According to the IRS, “The form of your pension distribution (lump sum, annuity, etc.) and the date your pension money will be available to you depend upon the provisions contained in your plan documents. Some plans do not permit distribution until you reach a specified age. Other plans do not permit distribution until you have been separated from employment for a certain period of time.”

The normal method for receiving funds from your pension is monthly payments for the rest of your life.

But if your plan does allow you to elect a lump sum distribution, you can perform a rollover just as discussed above regarding a 401(k) distribution to a rollover IRA. In this case, your funds remain tax-deferred until such time as you take them out. Such a distribution will require a 20% withholding by your pension plan administrator unless it is made directly from your pension plan to the IRA – highly recommended!

Conclusion

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There are many options available for taking distributions from a defined contribution plan, such as a 401(k), but they can come with some pretty notable consequences and even substantial penalties.

When it comes to distributions from a defined benefit plan, such as an employer pension, the options are generally more limited, but they too can come with consequences. Moreover, once a decision is made regarding distribution from a pension plan, it is irrevocable, so you are stuck with your decision.

Given the moving parts, key considerations, and options available with both types of retirement vehicles, it makes sense to consult with a retirement planner or investment advisor prior to making a decision regarding your hard-earned retirement savings.

Contact us today at (281) 699-8931 to set up an appointment to review your retirement plan and discuss your options.

 

Let Us Help You Achieve the Retirement You Deserve!

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