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"One Foot Out the Door"

by Greg Mermel, C.P.A.

Published in the "Money and Taxes" column in PerformInk on April 25, 2008

When exiting a regular (i.e., non-theatre) job, the question should arise about what to do with the balance in your 401k plan. I say “should” because many people have their erstwhile employers draw checks for the balance without considering any options. To these folks, this money is almost a form of severance pay: you can only get your hands on it if you leave, and you’ll start saving again at the next job. The check comes, it has taxes withheld, and they cheerfully spend the rest.

These folks also become pretty grumpy when I explain to them the tax consequences of their actions, that the taxes withheld from the check are nowhere near enough to cover the tax bill, and that they could have avoided tax altogether.

Do the Math

Payouts from 401k plans have federal tax withheld at a flat rate of 20 percent. You may be thinking, “I’m in the 15 percent tax bracket, so I should have change coming.” But there’s another tax involved. 401ks are retirement savings plans. The tax laws actively discourage you from tapping any retirement plan (401k, IRA or otherwise) by adding a ten percent penalty tax to any amount withdrawn before reaching retirement age. Retirement age for these purposes is age fifty-nine-and-a-half, and, before you ask, no, I do not know why.

The penalty tax, then, has absorbed half the withholding, leaving you with tax due even if you are only in the 15 percent bracket. Worse, if one has been at the job long enough to accumulate a significant balance, that can push you over into the 28 percent tax bracket.

If you truly need the money to live on between jobs, then having it at a high rate of tax is better than not having it. Otherwise, you have better options.

Move It

“Rollover” is not just a trick you might attempt to teach your dog. That’s also the way you can move money from your former company’s 401k plan to a different retirement plan. You may even have done a rollover in the past without realizing it. If you had an IRA with Mutual Fund Company X, and you switched to an investment with Mutual Fund Company Y, you did a rollover. So long as money goes directly from one retirement plan custodian to another, there is no tax consequence.

The question is, where to roll it? Some people are under the misapprehension that one can roll investments only from one 401k plan to another. You can, at least in theory, do this, but there are obstacles: you have to have found another job with a 401k plan, and it has to be a plan which allows money to be rolled in. Not all do.

The bigger question to me is why anybody would choose to, when there is a better option available. You can always roll the assets of a 401k plan into an IRA. Because it is a rollover, the annual contribution limits do not apply: I have seen 401k balances over $100,000 rolled into an IRA. If you move the money into your next employer’s 401k plan, you are limited to the six or eight or ten investment choices offered there, instead of the whole wide world available in an IRA. The new employer won’t match the money you have brought in from outside, only current contributions from your salary there (if that). The only theoretical advantage of rolling money into your new employer’s plan would be those rare circumstances where you can get a greater bargain investment in that company’s stock through the 401k plan.

But I have long preached that you should have only a small portion of your assets tied up in your employer’s stock. If you don’t believe me, talk to somebody who had a lot of money in the Tribune Company’s Employee Stock Purchase Plan last year. Ask how much he lost in the buyout. Warning: don’t try this with someone both drunk and bigger than you.

Ignore It

The last option is to leave the money where it is, in your former employer’s retirement plan. Again, I am not sure why you would want to, though a significant number of people do this. It has all the disadvantages of moving the money to your new employer’s 401k plan, and an additional negative: it keeps you mentally tied to your former job. Just as in the breakup of a relationship or marriage, I don’t think it healthy to keep too many ties to your ex.

Your former employer is probably not thrilled with the idea, either. It costs them money to maintain accounts: why should they spend money for ex-employees? Many plans that do not require that you liquidate your account (either by payout or rollover) shortly after leaving will still have a time limit -- maybe three years, maybe five. Let that limit pass, and you will find a check (and a tax problem) in your mailbox.

Because of some needed pension reforms, you might find that check anyway if you are not careful. These small, leftover accounts are often forgotten, and remain stuck in the investments chosen before the job change. Maybe that is OK, but most likely not. Employers will soon be required to roll over into an IRA-like account orphaned balances over $1,000, and to actively manage these accounts. That is anathema to these employers, who most often chose 401k plans so as to transfer responsibility for the investment of retirement funds from the employer to the employee. Employers have always had the authority to cash out former employees’ accounts under $5,000, regardless of the 401k plan’s other rules, and you can expect to see this used aggressively before the new rules take effect.

In Case Of Planning Failure

Even if you receive a check for your retirement plan balance, not all is lost. You can still do a rollover if you put that amount of money into an IRA within sixty days after you receive the check. Remember, though, that just signing over the check to your new IRA is not enough, because the tax withheld will still be treated as a distribution to you. You have to actually add money to cover the tax withheld, and wait until you file your tax return to get a refund or have it cover taxes you would otherwise have to pay.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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