Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

Preserving Your Retirement Benefits: The 401(k) Rollover

by Frank Armstrong
President, Investor Solutions, Inc.
www.fee-only-advisor.com

Americans are changing jobs at a pace that would have been unimaginable to our parents. The days of the lifetime job are over. Gone too are the days of the defined benefit pension plan with its monthly check arriving like clockwork with no thought or care required of the employee. Those plans are disappearing in favor of defined contribution plans like profit sharing, and 401(k) plans.

The newer plans are ideally suited to the needs of a more mobile work force. To an extent not possible with the older plan designs, benefits once vested are portable. The employee is free to take his accumulated pension assets with him when he leaves his job. But, it’s up to the employee to make wise choices in order to preserve and maximize the intended benefits. Far too many Americans are flunking this critical test.

In spite of potent carrots and sticks, the "leakage" of assets from the retirement system is shockingly high whether measured in terms of total assets or number of accounts not effectively rolled over. As you might suspect, these system failures are highest in smaller accounts, younger employees and lower income families. As you might also conclude, these are the very accounts that would benefit most from a successful rollover.

In an atmosphere where the majority of families will not have sufficient assets at retirement to support their pre-retirement standard of living, the loss of these assets is a national tragedy.

A Real-Life Example

Let’s look at what happens to a 30 year old with a $10,000 account at the time she changes jobs if she doesn’t make an effective rollover:

The employer must withhold 20% for taxes and penalties. So the employee receives a check for $8000.

Assuming that she doesn’t roll over the funds, next year at tax time, she is subject to a 10% penalty and ordinary income tax on the entire amount. If she is in the 28% bracket, that’s a $3800 tax, netting her only $6200!

If she wants to roll over into an IRA within the sixty-day window, she will not have all the funds available due to the withholding. She must come out of her own pocket for the $2000 withheld to complete the rollover. Otherwise, any amount not rolled over is subject to the penalty and tax.

If she does complete the rollover she can file for a refund next year. Meanwhile she has lent the $2000 to Uncle Sam.

The worst problem is that employees that change jobs and do not rollover their account systematically deplete their retirement funds. The preservation of the entire account value coupled with the enormous power of compounding tax deferred earnings should produce a significant accumulation. Had our heroine invested the $10,000 in a rollover for a net 10% return, it would grow to $174,494 at her age 60, or $281,024 at age 65.

The purpose of a retirement account is not to finance a luxury purchase or vacation. Retirement accounts are "sacred money" that should be conserved for its intended use. The tax code recognizes the importance of a secure retirement for Americans. So it provides retirement accounts with preferred tax treatment, while penalizing early withdrawals severely.

What should terminating employees do?

A "trustee to trustee" transfer of the funds from the 401(k) to an IRA will avoid the withholding, penalties, and taxes.

The transfer preserves the account and the tax deferral of future growth so that funds are available when needed to finance a secure retirement.

Specific steps for a stress-free, successful rollover:

- Open an IRA account with a brokerage or mutual fund.

- Obtain the account number and complete transfer instructions from the brokerage or mutual fund company.

- Direct human resources (or the pension administrator) to send the funds directly to the new account.

- Invest it sensibly to meet your future needs.

Remember, a tax advantage is a terrible thing to waste!