What are my 401(k) options?

It pays to know your options and their tax consequences.  

Once you leave your company, you must decide what to do with your retirement plan assets. Knowing your distribution options, and how they will affect your retirement savings, can make the difference between having a comfortable retirement and not having one at all. Here we look at some of the different tax effects of your options.

Tax-free options. 

  • Direct rollover into an IRA. One way to avoid any mandatory state or federal withholding taxes, as well as a possible 10% IRS penalty, is to directly rollover your entire plan into an Individual Retirement Account (IRA). An IRA is a tax-deferred account that can be used to receive retirement benefits distributed from an employer-qualified plan. Since all earnings continue to accumulate on a tax-deferred basis—and those earnings will be compounded—your funds can accumulate more rapidly than money placed in an otherwise identical taxable account.

    If for some reason you have already received your lump-sum distribution, minus the 20% mandatory withholding, all may not be lost. You have 60 days from the date you received your payout to invest these funds into an IRA, along with an additional 20% of your own money to cover the amount withheld. When you file your income tax return, you will receive credit for the 20% withheld. But remember, you only have 60 days to do this. If you fail to act within the 60 days, your entire payout will be subject to state and federal income taxes, a potential 10% premature distribution IRS penalty, and your accumulations tax-deferred status will be lost forever.

    Beginning January 1, 2015, you may make only one indirect (i.e. 60 day) IRA rollover in any 12-month period, regardless of the number of types of IRAs you own (see IRS Announcement 2014-32); however, you may continue to make an unlimited number of direct trustee-to-trustee transfers (transfers directly between IRAs) as well as unlimited rollovers from traditional IRAs to Roth IRAs (“conversions”). Neither New York Life, its subsidiaries, nor its Representatives can provide tax or legal advice, so please consult your tax advisor prior to effecting a rollover.
  • Transfer funds to your new employer’s plan. If your new employer’s plan accepts rollovers from another employer’s plan, you can transfer the funds directly to its 401(k) plan or other type of qualified employer plan, avoiding current income taxes and the 20% withholding tax.
  • Keep funds in your old employer’s plan. You may be able to keep your funds in your former employer’s plan. Your funds will continue to accumulate tax-deferred, and can later be moved to a new employer’s qualified plan or an IRA. If you are over the plan’s retirement age or age 62, your company may insist that you take a payout in order to decrease the plan’s administrative costs. If this happens, you still have the option to make a direct rollover to an IRA.

Consult with each employer’s Human Resources Department to learn about important plan features and rules. Be sure to compare these fees and expenses of each plan and investments that you are considering. Review plan documents and the IRA agreement, as well as the prospectuses for plan investment options and any other investments that you are considering. Your registered representative can help explain any new products being offered.

Taxable distribution option. 

Although taking a taxable distribution can give you access to the savings in your retirement plan, there are several things to consider when taking a lump-sum distribution:

  • Federal (and, if applicable, state) income taxes will take a “bite” out of your distribution. When you were making contributions to your 401(k), you most likely did so with pre-tax dollars. In addition, employer contributions to a qualified plan on your behalf were also tax deferred. Upon distribution, you have to pay current income taxes on all pretax contributions and earnings.
  • There is a 20% mandatory federal income withholding tax that is applied to eligible rollover distributions. If you elect to receive a check directly from your employer, you will only receive 80% of your distribution. In essence, if you expect to receive a check for $100,000, your employer will withhold 20%, or $20,000, and send you a check for $80,000.
  • A 10% IRS penalty may also apply (also known as a premature distribution penalty tax). Generally, if you are under age 59 ½ you will have to pay the IRS an additional 10% penalty when you file your federal income taxes next year. There are certain exceptions to this rule, such as death, disability, or if your form of benefit is a series of substantially equal payments.

Did you know…? 

Compare the after-tax accumulation of currently taxable and tax-deferred accounts with our Taxable vs. tax-advantaged savings calculator.

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