1. Changing Jobs or Retiring? Avoid 401(k) Decay! Sean Latterner Minneapolis Financial Group Seminar And Insurance Sales Presentation 1208 RI01140 610 Retirement Income Strategies
Thanks for joining me here today. I’d like to start by asking you a question: Would it be fair to say that your 401(k) is the largest asset you own, other than your house? In many cases, your 401(k) may even be worth more than your house? The point I’m trying to make here is that you’ve obviously worked long and hard to build that 401(k) balance, so it’s in your best interest to understand your options for handling your 401(k) once you prepare to leave your employer.
Over the next few minutes, I’ll explain what I mean by “401(k) decay”, and we’ll discuss your options for handling your retirement plan, as well as any special rules you should be aware of.
Make no mistake - 401(k) decay is my own personal description (not a recognized industry term) for what can happen to your 401(k) balance if you don’t know the ramifications of the choices available to you once you leave your employer. Specifically, I’m talking about the impact that taxes can have on your money if you decide to take your 401(k) in a lump sum check. For instance, most people under age 59½ will pay not only income taxes on the distribution but may also be subject to an additional 10% federal income tax penalty on withdrawals.
Here is a more detailed example of the “decay” that taxes can cause to your 401(k). Of Mary’s original $60,000 balance, $22,800 goes to pay taxes!
While it’s admirable that Mary wanted to pay off her car loan 30 years earlier, the logical question I’d want to ask Mary is: “What did you do with the monthly payments that you’d previously allocated to the car payment? Were you able to invest the phantom car payment in a vehicle that returned more than the annual percentage rate on the car loan? If yes, bravo! If no, what was the point of paying off the car loan early if you’re not further ahead financially?
What makes this case really baffling is that Mary had another job lined up 30 years ago when she left her old employer, so she never really needed the money from her 401(k) to live on. Unfortunately, Mary gave up far more than the $22,800 she paid in taxes, as you can see from this slide. In fact, had that $22,800 been left in a tax-deferred vehicle earning 8% annually over the last thirty years, it would have grown more than tenfold, to $229,429. And while Mary probably felt great about getting rid of that pesky $17,200 car loan, who would have guessed that had she let that money continue to grow tax-deferred at 8%, it would have grown to more than $170,000! That original car loan would now be worth enough to buy a home in many places! Overall, if she let the original $60,000 continue to grow tax-deferred at 8%, it would have grown to more than $600,000, before taxes. Even if at age 65 she decided to withdraw the entire balance, she’d still have $434,706 left after all federal income taxes were paid, assuming a 28% tax bracket.
What if Mary had decided NOT to pay off the car loan, but instead invested the entire $37,200 she received, after taxes from her original $60,000 401(k) into an annually taxable investment? While it would have grown (at an assumed 8% annually) to an impressive $374,331 in that thirty year period, this is still $60,000 LESS than the AFTER TAX amount of $434,706 that she’d collect had she let the $60,000 continue to grow tax-deferred. We haven’t even mentioned here an additional cost to Mary of choosing to invest her $37,300 in an annually-taxable investment. While that investment may earn 8% annually, it could be possible that up to 20% of that annual return - or 1.6% - may go to pay taxes. So yes, Mary did grow her $37,200 into $374,331 over that thirty years, but she also paid taxes every year on those gains…and that begins to cut into returns over time.
Obviously, I think most people can benefit from additional tax-deferral of their 401(k) balance. However, knowing your choices is the first step in making the right decision. Let’s take a look at these choices.
Assuming you don’t mind doing a bit of research on finding the right vehicle with which to fund an IRA, this can be the most flexible option for many people. And once you roll your 401(k) to an IRA, you may then choose to convert your IRA to a Roth IRA. (Consult with your tax advisor to see if you qualify for a Roth IRA) Roth IRA’s may provide the most tax relief for investors with long time horizons who expect their income tax bracket to increase upon retirement. Even those younger than 59½ who need income immediately may still benefit from an IRA, through the tapping of a special provision in the Internal Revenue Code called Section 72 (t). This may allow the taxpayer to collect an income - subject to income taxes but free from the 10% federal income tax penalty - from the IRA if certain conditions are met. (Again, please consult a qualified tax advisor for more details on this provision.) Loans, however, are not permitted in an IRA. If this is important to you, you may not be interested in an IRA.
This is obviously the path of least resistance - but is it the best route for you to follow? If you are delighted with your current options and you don’t want to take the time and effort required to selecting other options, this may be the best choice for you.
Rolling your 401 (k) into your new employer’s plan may also have appeal IF you like the new choices. But again, you are limited to the new employer’s choices, and your new employer may even require you to wait a certain period of time prior to transferring your old balance.
Here’s where 401(k) decay comes into play. (Alright, that might be too much rhyming. Enough already). For some people, taking a lump sum check may be the answer. These folks might include: Those who won’t be subject to the 10% federal income tax penalty Those who either can’t subsist without the money or who have had the money specifically earmarked for a vacation home or other special purchase. Those who have substantial alternate sources of income – if so why take it?
Again, you need to know the impact of electing to receive a check. Uncle Sam will want his money after all those years of tax-deferral, and unless you meet the above exceptions, he’ll want to collect 10% additionally in the form of the early withdrawal federal income tax penalty.
I want to thank you for coming today. And while I’d be delighted to help you map out a strategy for handling this most important decision, please don’t forget that the quality of your financial future is ultimately in your hands. Make the right choice for you!
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