Make the Right Moves with a Pension Payout
RETIRE WORRY-FREE
From the Editors of Kiplinger’s Personal Finance
A generation or two ago, you might have gone to work right out
of college and stayed with the same company until you retired at
age 65. Your devotion would have been rewarded with a tidy pension
and perhaps the proverbial gold watch as well. But like so many
other aspects of retirement planning, that storybook scenario is
far less common today.
Americans jump jobs the way a track star jumps hurdles—fast
and frequently. And with each job move (voluntary or otherwise),
there may come a major decision: finding a new home for the
retirement money you’ve built up in a 401(k) or other employer-sponsored
retirement plan. If your money is in a defined-benefit
plan you avoid this predicament because the company usually keeps
the money until you reach retirement age and then pays you your
due. With other kinds of plans, though, your vested benefit
is yours to take when you leave the job.
If you’ve been with an employer for ten, 15, 20, or more
years, the payout could be the largest sum of money you’ve
ever received at one time. Even after just a few years, the payment
can be impressive. But a misstep with that money could limit your flexibility,
erase valuable tax benefits, and cost you out-of-pocket cash
up front. (And thanks to changes in the tax law, you’ve got
a new trap to avoid; we’ll show you how to protect yourself
later in this article.)
First, understand that most of the billions of dollars in retirement
cash paid out by companies each year goes in lump sums to individuals
under 55 who are changing jobs. But other events can trigger a
distribution:
You accept an early retirement offer;
The company you work for changes hands through a sale or merger;
Your company terminates the retirement plan;
You are laid off or fired;
Your spouse dies and you’re the beneficiary of his
or her retirement plan; or
You become permanently disabled.
“Stop Me Before I Spend!”
No matter why retirement money becomes available to you early,
your basic goal is to resist the temptation to spend any of the
money. It’s easy to get starry-eyed over a large check. Heck,
why not blow just a bit of it on a few goodies? What’s the
harm?
Well, money from a company plan is generally subject to an immediate
10% tax penalty if withdrawn before age 55. Plus, each dollar withdrawn
will be taxed at your regular income-tax rate for the year. That’s
money you’ll never get back. Ultimately, someone in the 28%
tax bracket in 2005 who receives a $25,000 payout from a pension
plan and does not reinvest in another retirement plan will lose
at least $9,500 of that sum to taxes and penalties. State and local
taxes could make the bite even bigger.
The threat of losing so much to taxes and penalties should encourage
you to roll over the money into an individual retirement account
(IRA) where it will continue to grow for your worry-free retirement.
That’s the best choice for almost everyone, but you’d
never guess that based on what actually happens: Almost two-thirds
of the pension dollars paid in lump sums each year is spent outright.
Beyond what you lose immediately to taxes and penalties, the real
pain of spending the money comes over the long haul to retirement.
The dollar you spend now, if it had been left to grow free of taxes
for another ten or 20 years or more, would have become many, many
dollars in the future. For example, with 20 years to go until retirement,
a $25,000 payout would become $116,500 if it continued to grow
at an 8% annual rate. A $10,000 payout invested at 10% for 15 years
becomes $41,800; a $90,000 payout that earns 7% will become $177,000
in ten years. By spending the money, you throw away the growth
potential that money had for your worry-free plan.
Avoid the Pension-Payout Trap
The latest attempt to convince workers not to make the mistake
of spending retirement money early is a 20% withholding tax that
applies to payouts made directly to employees whether they retire,
quit, or lose their jobs. Fortunately, it’s easy to dodge
this confiscation. To avoid seeing 20% of your money go immediately
to the IRS—as a forced down payment on a tax bill you may
or may not owe—all you have to do is tell your employer to
send your retirement money directly to an IRA or to your new employer’s
retirement plan if it accepts such rollovers. As long as the payout
does not pass through your hands, there is no withholding.
If you’re changing jobs and your new employer permits rollovers
into its retirement plans, you can have the money shipped directly
to the new employer’s plan.
The direct rollover to an IRA is likely to be your best choice,
even if you believe you may need to spend some of the payout. You
can immediately tap your IRA without worrying about the 20% withholding.
If you’re under age 591/2, you will still pay a penalty and
taxes on what you withdraw, but by running the money through an
IRA, you avoid withholding.
SPECIAL CIRCUMSTANCES. In some situations, however,
opting for the IRA would be a mistake.
This applies, for example, if you are over age 55 but not yet
591/2 and you know you need to spend part of the payout—to
launch your own business, perhaps. No matter what your age, the
part of the payout that does not go into an IRA will be taxed at
your top rate. But age does play a role in whether you’ll
be stuck with the 10% penalty for early withdrawal of retirement
funds. When company plans are involved, early is defined
as before age 55. When it comes to IRAs, however, early is before
age 591/2.
Therefore, if you are over 55 but under 591/2, having the money
transferred to an IRA extends the threat of the early-withdrawal
penalty. If you are in this age group and know you will need to
use part of the company payout, ask your employer to split the
payout. As much as possible should go directly to an IRA—to
hold off both tax and penalty. Ask that the remainder be paid directly
to you. Tax will be due on that amount and 20% will be withheld
for the IRS, but you’ll avoid the 10% penalty.
The other circumstance in which direct transfer would be a mistake
is if you intend to take advantage of the ten-year averaging method
for reducing the tax due on the payout. Averaging, which is currently
available only to taxpayers who were born before 1936, is discussed
later in this chapter. The trap, though, is that averaging is available
only for payouts from company plans. If you have the money deposited
in an IRA, you forfeit the right to use averaging. To take advantage
of it, you must take the money directly from the company plan,
and that means you’re stuck with withholding.
Note that the withholding is not a new tax; it’s a sooner-rather-than-later
tax. If you wind up owing less than 20% of the amount in taxes,
you’ll get the excess back as a tax refund when you file
your return for the year in question.
Transfer the Money Directly to a “Rollover” IRA
Clearly, the best bet for most taxpayers is to have the payout
transferred directly to an IRA. The law that imposed the 20% withholding
rule also demands that employers offer to make the direct transfer
and warn employees about withholding if they turn down that offer.
The introduction of the Roth IRA in 1998 could cause some confusion
here. Should you roll over the company-plan payout into a traditional
IRA or a Roth? Actually, you have no choice—it must go to
a traditional IRA. You could immediately roll the money from the
old-fashioned IRA into a Roth, but doing so would trigger a tax
bill on the full amount of the rollover, as discussed in Chapter
7. Using this two-step method to roll part or all of your company
plan into a Roth could make sense, depending on your circumstances.
After all, all future earnings would be tax-free rather than simply
tax-deferred. But for our purposes here, the key is keeping your
options open. The way you do that is to have your money transferred
directly to a traditional rollover IRA.
As noted above, using the direct transfer to put off paying taxes
can put a ton of money in your retirement plan’s pocket.
The advantage is worth repeating.
Say, for example, you’re 45 and about to leave your job
with a $50,000 payout from a profit-sharing plan. If you
took it as spending money instead of rolling it into an IRA, you’d
owe a $5,000 penalty plus $14,000 in taxes if you’re in the
28%-tax bracket. But if you roll the money into an IRA, that $19,000
remains a part of your nest egg, free to continue growing tax-deferred.
Over 20 years, that $19,000 alone will become $156,600 if it earns
the average historical return of 10.4% for large-company stocks—and
that’s not counting the rest of the payout. The larger the
lump sum, the bigger the benefit of continued tax-deferred compounding.
There’s no limit on how large a pension distribution you
can transfer into a rollover IRA.
HOW THE ROLLOVER WORKS. A rollover is a tax-free
shift of assets from one “qualified” (IRS-approved)
retirement plan to another—commonly from a company profit-sharing
or 401(k) plan to an IRA. These are the key rollover rules:
If the transfer is made directly from your employer
to a new trustee (the bank, brokerage firm, mutual fund,
or insurance company that establishes your account), no tax is
withheld from the payment.
But if the money is paid to you in a lump sum,
it is subject to a 20% withholding tax taken out by your employer.
Thus, on a $50,000 lump payment, you would receive only $40,000;
the other $10,000 would go to the IRS. You would still have the
right to roll over the full $50,000 to an IRA yourself, and doing
so within 60 days would avoid taxes and penalties. But you’ll
have to come up with the $10,000 that was withheld, then apply
to get it back as a tax refund at tax time.
Only money from a retirement plan can be rolled
over to continue to grow tax-deferred for your retirement.
Severance pay and bonuses are not eligible for an IRA rollover.
Any money representing after-tax contributions to
a plan may not be rolled over to an IRA. You do, however, get to
take that money tax-free. There’s no tax, penalty, or withholding
on that portion of the payout, since you paid tax on the funds
before they went into the company plan. Earnings on those contributions
can be rolled over into a IRA.
As noted above, if you select an IRA rollover,
you forfeit the right to use ten-year averaging. However, if your
payout is shipped to a new employer’s plan you retain that
right. And, if the money goes to an IRA and is later rolled into
a new employer’s plan, you regain the right to use averaging
when you exit from that plan.
Rollover versus Standard IRA
A rollover IRA—one specially created to receive a pension
payout—differs only slightly from a standard IRA. Even if
you already have a regular IRA, your company-plan payout should
go into a separate, newly established rollover IRA. This preserves
your right to later roll the entire amount, including earnings,
out of the IRA and into a new employer’s pension plan. If
you blend rollover funds into an existing standard IRA, or make
any additional deposits to the rollover IRA, you lose the option
to make that move even if the new employer’s plan permits
it.
A rollover is your best choice if you don’t need the money
now and aren’t likely to need it in the foreseeable future.
The younger you are, the more you’ll benefit from putting
the entire distribution into an IRA because there will be more
time for your nest egg to grow tax-deferred.
Rollover to Another Qualified Plan
If your new employer has a retirement plan, you may be able to
have your payout transferred directly from the old company to the
new. This, too, avoids any penalties or tax bite for now. Plus,
you preserve your ability to use forward averaging later on.
If the new plan permits rollovers, a deciding factor will be the
choice of available investments in the new plan. Find out what
investment options the new company’s plan offers and how
they performed in the past. The choices should include at least
a couple of stock funds, an income fund, and perhaps an international
fund. If the plan offers little choice, or poor investment performance
in the past, you’ll be better off in a rollover IRA where
you can make your own investment selections.
Tap the Keogh Advantage
If you have a Keogh plan—funded, for example, with income
you earned moonlighting as a self-employed consultant while keeping
your day job—you have another rollover option. Instead of
rolling the funds into an IRA or a new employer’s plan, roll
them directly into your Keogh account, tax- and penalty-free.
This move keeps the IRS at bay and lets you retain the right to
save taxes later with forward averaging. You also have the flexibility
to invest the funds as you wish. A rollover to your Keogh will
not affect the size of your regular annual contribution to the
plan. What’s more, Keogh money can be withdrawn penalty-free
after age 55 if you decide to retire early, while money pulled
out of an IRA will generally be penalized if you are under age
591/2.
Stay Put
Unless your plan is being terminated, you probably have the option
of leaving the money in your ex-employer’s 401(k) or other
retirement program. Companies are required by law to allow employees
whose accounts total more than $1,000 to leave their money right
where it is or to provide an automatic rollover into an IRA account,
unless the participant chooses otherwise. The plan administrator
must notify the participant in writing that the distribution can
be transferred to an IRA. Some companies allow employees to leave
their funds in the company plan until they reach 701/2.
In some circumstances, staying put might be the best choice. For
example, if a portion of your money is invested in company stock—and
you expect the company to do well—you can leave your money
alone. You still have the right to roll it over into an IRA at
a later date. Or you might leave it and take the payout at a later
date—paying the 10% early-withdrawal penalty if you’re
under age 591/2 when you make the withdrawal—and perhaps
take advantage of forward-averaging tax benefits, too. Your
money will continue to grow, tax-deferred, although you give up
the kind of investment flexibility you would gain by rolling
the assets into an IRA.
On the flip side, leaving money invested in shares of a
company you no longer work for can boost the risk level a notch.
Since you’ll no longer be involved with the firm day
to day, you may not have as good a feel for the company’s
prospects. A common mistake is falling in love with your own company’s
stock and leaving your nest egg invested in it out of loyalty.
Such a move can turn sour if the company’s fortunes turn
south.
If you decide to stay put, keep close tabs on this part of your
plan. Once you start building assets in a new plan elsewhere, there
may be a tendency to let this one slide. Figure on reconsidering
your stay-put decision once a year.
START PERIODIC PAYMENTS. Your employer’s
plan may also allow you to start receiving periodic payments keyed
to your life expectancy, no matter what your age. Even if you’re
under age 55, there won’t be a penalty as long as the steady
payments continue for at least five years and until you reach age
591/2. The money you receive will be taxed as income, but it won’t
be subject to withholding.
Choosing periodic payments is a good way to help fund early retirement.
Even if you roll the money directly into an IRA, you can take it
out later using periodic payments. And, as noted earlier, there’s
no mandatory withholding if the money goes first to an IRA.
Forward Averaging to the Rescue?
Ten-year forward averaging is a special computation method—available
only to taxpayers born before 1936—that taxes a payout all
at once, but the bill is figured as though you received the
money over a number of years. Although you must actually pay the
tax right away, the amount due will be significantly less
than if the full amount was heaped on top of your other taxable
income. To use forward averaging, your lump-sum distribution must:
come from a qualified plan in which you have participated
for at least five years before the distribution;
represent your entire interest in the plan and be paid to you
within a single tax year; and
be paid after you leave your job or after you reach “normal” retirement
age for your company’s plan.
So what’s the big deal? Well, it could greatly reduce your
tax bill. If the payment is less than $70,000, current rules make
part of the money tax-free. And the bill on the taxable portion
is figured as though you got the money in equal chunks over five
or ten years. That means more of it is taxed in lower brackets
than if you lumped it all on top of your other income in the year
you receive the payout. You have to pay the tax bill all at once,
but averaging could reduce what you owe.
Averaging makes sense if you need to spend a good part of your
payout quickly. Otherwise, it’s usually better to ignore
this tax break and roll your money over into an IRA. The longer
you keep that tax shelter going, the more likely the benefits
will exceed those of averaging.
The key point: Whenever you have a lump-sum payout coming, be
sure to check on the status of averaging and weigh the possible
advantages if you qualify.
Planning for Change
Planning a job jump soon? If so, start asking questions and gathering
information about your current employer’s pension plan and
possible new homes for your money. Request investment and IRA account
information from banks, mutual funds, and brokerage firms
that are candidates for your rollover IRA business. You’ll
want answers to these questions about your plan at work:
Must the payout be in cash or can securities
be rolled directly (without being liquidated) into an IRA or other
qualified plan? If your employer is a major corporation—an
Exxon, IBM, or Procter & Gamble, for example—and you
own company shares in your retirement account, you may want to
hold on to that stock. Find out whether shares can be transferred
with little or no cost. If taking your money means the stocks must
be liquidated, however, you may want to stay put.
Can you leave the money where it is? If your
current investments are performing well, and the rules permit you
to stay in the plan even if you leave the company, that’s
an option you’ll want to consider. Do some comparison shopping
with similar types of investments offered elsewhere before you
decide. If the money’s in a growth-stock fund, for example,
how are other growth-stock funds performing?
How long will it take to complete the payout/transfer
process?
What portion of the payout, if any, represents
voluntary after-tax contributions you’ve made? This portion
can’t be rolled over into an IRA, but it won’t be taxed
when you withdraw it.
Investing the Payout Cash
Once you’ve kept the IRS at bay and found a new home for
your retirement-plan money, you can turn your attention to where
specifically the payout should be invested. The basic idea
is to keep the money on the growth track for the ten, 15, 20, or
more years you still have to go until retirement.
The great opportunity in a rollover IRA is the freedom to choose
a diverse array of investments for this portion of your retirement
nest egg. Stocks are the best bet for long-term growth. The historical
10.4% annual return for large stocks, and an even better 12.7%
for small-company stocks, stands head and shoulders above the 5.5%
historical return on long-term government bonds and inflation’s
average 3.0% annual bite.
For payouts of less than $50,000, mutual funds are an ideal vehicle
because of their built-in diversification. Go with one of
the major fund groups and you can choose among several conservative
stock funds, small-company funds, international funds, and balanced
funds that hold both stocks and bonds.
Keep the big picture in mind when you make your investment selections.
For example, if your spouse’s 401(k) plan money is invested
in highly conservative guaranteed investment contracts, you can
weight this portion of your total nest egg more heavily toward
small-company and other growth-oriented stocks.
The Golden Handshake: Sizing Up an Early-Payout Offer
One reason you might have to deal with a payout decision is an
offer from your employer to, in effect, take your money and run.
Thanks to the phenomenon of “corporate downsizing,” these
payouts, or early-retirement offers, can be a big opportunity to
advance your plans for a worry-free retirement. Here, however,
the choices become more complex as companies attach a variety of
incentives to sway your decision to move on.
Should you bite if an early-retirement payout is offered? Maybe.
Some early-retirement plans are super deals. One may give you the
opportunity to launch a new career or start a business. In effect,
an early-retirement incentive is a bribe to get you to quit your
job so your employer can cut its long-term costs. But analyzing
an early-retirement offer isn’t easy—especially because
early-exit deals can be one-time offers good for a short “window” period
of a few months or even weeks. Financial incentives in the offer
might include the following:
Enhanced defined-benefit pension.
Early-retirement deals commonly increase the monthly pension checks
you have coming by as much as a third. Often that’s accomplished
by adding three to five years or more to your tenure at the
company for purposes of the formula that calculates your monthly
benefit.
A lump-sum payment pegged to your salary level
and length of service. Be aware that any such severance payments
could not be rolled over into an IRA and would be taxed as regular
income.
A social security “bridge” to provide
extra income until social security benefits kick in at age
62.
Extended health and life insurance benefits.
Golden Handshake Checklist
If your employer makes an early-retirement offer, here are the
key points to consider when making your decision:
What will your pension benefits be if you
accept the offer? Get the dollar details. How does that compare
with what you’d get if you continued working at the company?
What are your employment prospects elsewhere? If
you’ve considered moving on anyway, this is a good time to
polish your résumé and look around. With luck, you’ll
walk away with a golden handshake from your current employer and
capture a better job.
If you plan to take an early-retirement offer before landing
another job, take stock of your financial standing now.
Do you have ample savings, without dipping into retirement funds,
to get by until you land another position?
Where will you put your early-retirement lump-sum payout? Your
choices are spelled out earlier in this article.
Will any part of your payout—in the form
of severance or a bonus, for example—be counted as ordinary
income and thus be fully taxed?
What happens if you reject the offer? This may
involve some guesswork and sleuthing on your part. Just how badly
is the company doing? Will salary increases stop if you stay? What
about bonuses? If there’s a chance that the ultimate early-retirement “offer” will
be in the form of a layoff, consider taking the money now.
If the company’s “voluntary” plan doesn’t
seem so voluntary for older workers, you should know
that federal law prohibits companies from discriminating against
older employees. If you decline early retirement, it should not
affect your future opportunities or working conditions.
Excerpted from Retire Worry-Free from the Editors
of Kiplinger’s Personal Finance. Copyright © 2004
by Dearborn Trade Publishing. All rights reserved. Excerpted
by arrangement with The Kiplinger Washington Editors, Inc. $17.95.
Available in local bookstores or call 800.245.2665 or click
here.
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