401k Decay


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  • 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!
  • 401k Decay

    1. 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
    2. 2. <ul><li>What is 401(k) Decay? </li></ul><ul><li>Your choices for handling your 401(k) </li></ul><ul><li>Special rule for distributions </li></ul><ul><li>The quality of your retirement is in your hands </li></ul>
    3. 3. <ul><li>It is the erosion of your 401(k) balance due to taxes assessed upon a lump sum withdrawal. </li></ul>What is 401(k) Decay? <ul><li>All investors are subject to income taxes on withdrawals </li></ul><ul><li>Investors younger than 59 1 / 2 may be subject to an additional 10% federal income tax penalty on withdrawals </li></ul>
    4. 4. Example of “401(k) Decay” <ul><li>Mary decides to cash in her 401(k) </li></ul><ul><ul><li>28% of the balance goes to pay federal income taxes </li></ul></ul><ul><ul><li>10% goes to pay the “pre 59 1 / 2 ” withdrawal federal income tax penalty </li></ul></ul><ul><li>Mary’s balance post-taxes is $37,200 </li></ul><ul><ul><li>She uses $17,200 to pay off her car loan </li></ul></ul><ul><ul><li>She invests the remaining $20,000 in an investment </li></ul></ul><ul><ul><li>earning 8% </li></ul></ul><ul><li>Mary Barton </li></ul><ul><li>Age 35 </li></ul><ul><li>28% Tax Bracket </li></ul><ul><li>(Assumption: No special lump sum tax treatment is available.) </li></ul><ul><li>$60,000 401(k) balance </li></ul><ul><li>Changing jobs </li></ul>
    5. 5. 30 Years Later, Mary is 65 and Ready to Retire <ul><li>The car she paid off 30 years earlier with the $17,200 from her post-tax 401(k) is worth $0, and long gone </li></ul><ul><li>The remaining $20,000 she invested in an investment @ 8% is now worth $201,253 </li></ul>NOT TOO SHABBY, RIGHT?
    6. 6. WRONG!!! <ul><li>Since Mary joined another company 30 years ago, </li></ul><ul><li>she never really needed the money from her 401(k) </li></ul><ul><li>when she cashed it out. </li></ul>* Examples assume 8% average annual return. This return is for illustrative purposes only, and is not meant to represent the performance of any MassMutual product. <ul><li>What she gave up by cashing it out: </li></ul><ul><ul><li>$229,429* - This is what the $22,800 she paid in income and penalty taxes would have grown to; </li></ul></ul><ul><ul><li>$173,078* - This is what the $17,200 she used to pay off her car loan would have grown to (an expensive car!) </li></ul></ul><ul><li>What she’d have if she had let her $60,000 continue to grow </li></ul><ul><li>tax-deferred: </li></ul><ul><ul><li>$603,759* - (before taxes) </li></ul></ul><ul><li>What she’d have even if she cashed out the entire $603,759 </li></ul><ul><li>today (at age 65 after taxes, assuming a 28% tax bracket): </li></ul><ul><ul><li>$434,706* </li></ul></ul>
    7. 7. <ul><li>What if Mary had not paid off the car loan, but </li></ul><ul><li>invested the $37,200 after-tax amount? </li></ul><ul><li>Over 30 years it would have grown to $374,331 - much better, but… </li></ul><ul><li>$60,375 LESS than her after-tax amount today if she let the original $60,000 grow tax-deferred! </li></ul><ul><li>This doesn’t even take into account the $ she pays in taxes each year on her currently taxable investment </li></ul>
    8. 8. Your Choices for Handling Your 401(k) <ul><li>1. Transfer your balance directly to a Rollover IRA, or to another eligible retirement plan </li></ul>HOW DO THESE CHOICES COMPARE? <ul><li>2. Leave your balance in your former </li></ul><ul><li>employer’s plan; </li></ul><ul><li>3. Transfer your balance to your new </li></ul><ul><li>employer’s plan; </li></ul><ul><li>4. Receive your balance - after taxes - in a check. </li></ul>
    9. 9. Option 1 Transfer Your Balance To A Rollover IRA <ul><li>ADVANTAGES </li></ul>DISADVANTAGES * Subject to income qualifications; consult your tax advisor <ul><li>Maintain tax-deferral and avoid current taxation </li></ul><ul><li>Flexibility: You may choose an investment that meets YOUR needs </li></ul><ul><li>May convert to a Roth-IRA* </li></ul><ul><li>Those <59 1 / 2 who need income may avoid penalty taxes with IRC Section 72(t) provisions, allowing for substantially equal periodic payments </li></ul><ul><li>YOU need to research appropriate vehicles to fund your IRA </li></ul><ul><li>No loans permitted in an IRA, while some employer plans do allow them </li></ul><ul><li>Conversion to a Roth IRA subjects amount converted to current income tax. </li></ul>
    10. 10. Option 2 Leave Your Assets in Your Former Employer’s Plan <ul><li>Your current strategy can continue without interruption </li></ul><ul><li>No need to take any action - so it’s simple </li></ul><ul><li>Maintain tax-deferral and avoid current taxation </li></ul><ul><li>You’re limited to the plan’s investment choices </li></ul><ul><li>You may receive LESS educational information about your plan, as compared to current employees </li></ul><ul><li>Some plans impose limits on withdrawals available to former employees </li></ul>ADVANTAGES DISADVANTAGES
    11. 11. Option 3 Move Your Balance to Your New Employer’s Plan <ul><li>Maintain tax-deferral and avoid current taxation </li></ul><ul><li>ALL your employer-sponsored retirement assets will be in one plan </li></ul><ul><li>Some employer plans don’t permit transfers, or have a waiting period </li></ul><ul><li>Your new plan may limit investment choices </li></ul><ul><li>The plan may limit withdrawals or other access </li></ul>ADVANTAGES DISADVANTAGES
    12. 12. <ul><li>Once all taxes are paid, the money is yours to use as you wish </li></ul>Option 4 Receive Your Plan Assets As A Distribution (Check) From Your Former Employer <ul><li>Income and penalty taxes could take a substantial portion of your distribution </li></ul><ul><li>The temptation to spend what’s left after taxes can be overwhelming; once spent it’s gone forever </li></ul>ADVANTAGES DISADVANTAGES
    13. 13. Special Rules for Distributions <ul><li>All distributions are subject to both federal and state income taxes, if applicable, </li></ul><ul><li>If you are under age 59 1 / 2 , you will pay an additional </li></ul><ul><li>10% federal income tax penalty, unless: </li></ul><ul><ul><li>You are disabled </li></ul></ul><ul><ul><li>You’ve exercised the 72(t) provisions for receipt of substantially equal periodic payments (see brochure for more details) </li></ul></ul><ul><ul><li>You’ve attained age 55 before leaving your employer </li></ul></ul><ul><ul><li>You’ve incurred medical expenses allowable as a medical expense deduction. Distributions for medical expenses may not exceed the amount of the expense without incurring the federal tax penalty. </li></ul></ul><ul><ul><li>Certain other exceptions from the 10% federal tax penalty may apply. </li></ul></ul><ul><li>If you are over age 59 1 / 2 , the 10% federal income tax penalty doesn’t apply </li></ul><ul><ul><li>Special tax treatment may be available for certain distributions </li></ul></ul>Consult your tax advisor for details on these tax treatments So You Want A Check Anyway? Know the Facts:
    14. 14. The Quality of Your Retirement Is In Your Hands <ul><li>Understand your choices </li></ul><ul><li>Compare the merits and disadvantages of each choice </li></ul><ul><li>Choose a course of action that you won’t regret in the future </li></ul><ul><li>Work with a professional with whom you’re comfortable </li></ul>
    15. 15. Important Disclosures <ul><li>Annuities do not provide any additional tax advantage when used to fund a qualified plan. Investors should consider buying an annuity to fund a qualified plan for the annuity’s additional features, such as lifetime income payments and death benefit protection. </li></ul><ul><li>Annuity products are issued by Massachusetts Mutual Life Insurance Company and C.M. Life Insurance Company. C.M. Life Insurance Company, 100 Bright Meadow Boulevard, Enfield, CT 06082, is non-admitted in New York and is a subsidiary of Massachusetts Mutual Life Insurance Company, 1295 State Street, Springfield, MA 01111-0001. </li></ul>
    16. 16. © 2008 Massachusetts Mutual Life Insurance Company, Springfield, MA. All rights reserved. www.massmutual.com. MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliated companies and sales representatives.