Over the last few months I’ve gotten a lot of questions regarding 401k rollovers and IRA accounts. I’d like to take a moment to answer six questions which I get somewhat frequently and may be good for investors to know:
• Can I withdraw 401k funds while still in service at my job?
• Once my funds are in an IRA, how easily can they be accessed?
• What are the various limitations on making deductible contributions to an IRA account? Who can and who can’t?
• What if I make a mistake on my tax return regarding my IRA contributions? For example, what if I make an excess contribution? Will I be penalized? How will the IRS know?
• What’s the story with RMD? Can I make a contribution in the year in which I turn 70 ½?
• Can contributions be made to an IRA for a non-working spouse?
1. Can I withdraw 401k funds while still in service at my job?
This is commonly referred to as an in-service rollover. Unfortunately, it’s not allowed in the large majority of corporate retirement plans. Unlike IRA accounts which are generally very mobile, 401k accounts usually can only be accessed when a triggering event occurs. The most common triggering events are as follows:
•Attaining retirement age which is 59 ½ and in rare circumstances 62 or 65.
•Terminating your current employment generally allows you to bring your 401k or other defined contribution plan with you. Certain plans may have vesting schedules if they involve stock options or deferred compensation, but vested account balances are commonly rolled over into IRA accounts and other qualified retirement plans.
•If you pass away the assets in your retirement plan can be distributed to your beneficiaries.
•If your employer terminates the plan without replacing it, you can usually move the money into an existing IRA or establish a new one.
If none of these events occur, you may be stuck with your current 401k plan. The underlying reason in-service withdrawals are not permitted is that 401k plans are supposed to have a certain degree of unanimity between the employees. Employers have a fiduciary responsibility when overseeing the plan and allowing funds to be invested outside the realm of one plan would make it impossibly difficult (and expensive) to monitor operations. What if an employee invested their life savings in a single stock? These kinds of scenarios can be avoided by maintaining one plan with specific investment options.
As a side note, people often confuse in-service withdrawals with hardship provisions. Most plans allow participants to access funds penalty-free if they fall within the guidelines of a hardship withdrawal. This can involve paying medical expenses or mortgage and rent payments in cases where you otherwise couldn’t come up with enough money. Again, the reality here is that you should get comfortable with your investment options at work because you likely will be using them until you reach retirement age.
2. Once my funds are in an IRA, how easily can they be accessed?
IRA accounts are certainly more flexible than 401k accounts—this is the primary reason people choose to process 401k rollover. Again, the reason for this is 401k plans are corporate retirement plans designed primarily for groups and IRA accounts are designed to come in different varieties to please individuals. Once your funds are in an IRA you can request a distribution without it getting blocked like it would in a 401k. However, in both IRA & 401k accounts, withdrawals are subject to ordinary income taxes and a 10% penalty if you’re under age 59 ½. Any time you take a distribution from a traditional IRA (not a Roth IRA) the amount of your distribution is treated as taxable income. So, if you earn $30,000 working and take a $10,000 IRA distribution and have no other income sources, you’ll pay tax based on $40,000 of income. This is the reason why people often take distributions slowly and over time rather than in one lump sum. The tax burden is just too great, especially if you’re paying a penalty as well.
Even though you can take distributions from your IRA (with the possibility of tax consequences and/or IRS penalties) people often tap other income sources before liquidating IRA accounts.
Similar to a 401k, the IRS may allow penalty-free hardship withdrawals from traditional IRA accounts in certain circumstances; this could be up to $10,000 for a first-time home purchase or perhaps money to pay tuition for a family member. You won’t have to pay this money back but you will pay tax on it come April. Hardship withdrawals are not exempt from taxes.
3. What are the various limitations on making deductible contributions to an IRA account? Who can and who can’t?
IRA contributions are traditionally designed for employees who are not covered by a company retirement plan. For example, any of the millions of people who work for small businesses around the country which don’t offer a 401k or other qualified retirement plan would be encouraged to contribute to an IRA. Deductible IRA contributions are also not designed to help wealthy and high-earning individuals defer tax. This is why income limitations exist which prevent the deductibility of an IRA contribution for higher income earners. The phase-outs start at $85,000 for couples filing jointly and $53,000 for single individuals. You can still contribute money to an IRA if you earn more than that, but you can’t deduct it from your taxable income.
If you are covered by a retirement plan but haven’t contributed any money to it, you can still take advantage of an IRA. Most people probably wouldn’t choose to do this because the contribution limits for 401k plans are considerably higher than IRA limits. Also, many 401k plans offer a company matching component which is very valuable to long-term savings goals. That being said, if you don’t contribute at all to your 401k, you can make the deductible IRA contribution instead. We’ll cover non-working spousal contributions below.
4. What if I make a mistake on my tax return regarding my IRA contributions? For example, what if I make an excess contribution? Will I be penalized? How will the IRS know?
First, when you make a contribution to an IRA, the bank or other custodian will report the amount of your contributions to the IRS. If a discrepancy exists between what you put on your return and what the IRS receives regarding your contribution, you could get a note about it in the mail. It may not be an audit—it may just be a bill or notice of the problem. It’s not the biggest deal but often a pain to deal with tax forms after April 15th. We see it all the time at my firm and often it’s an IRS error, a reporting error from the custodian, or an honest mistake from the client.
The deadline to remove an excess contribution and avoid the 6% penalty is the due date for your individual return (generally April 15th) or your extension deadline. If the time for filing the return has passed, the individual can still withdraw excess contributions without incurring a penalty tax and without being required to include the excess contribution in their gross income if, the following two conditions are met:
•The participants total contributions for the year did not exceed $5,000 (2008) or $6,000 if over age 50.
•The individual did not take a deduction for the excess contribution.
Individuals can simply leave the excess contribution in the IRA and just pay the 6% penalty, and by contributing less in the following year can avoid the cumulative effect of the 6% penalty.
5. What’s the story with RMD? Can I make a contribution in the year in which I turn 70 ½?
You are required to start withdrawing money from your IRA starting in the year in which you reach age 70 ½. Most people choose not to continue making contributions at this point because the older you get, the more counter-intuitive it becomes. The amount you must take is based on a formula which estimates how long it will take to liquidate your total account around the time of your expected death. Your RMD increases each year as you get older. Yes, it’s a bit morbid but it ensures that the IRS gets paid. The IRS doesn’t want you deferring taxes forever and they certainly don’t want that tax-deferral getting transferred to your kids who are much younger!
Remember, RMD applies only to traditional IRA accounts—not to Roth accounts. Also, in certain circumstances with some qualified retirement plans, individuals can avoid beginning RMD if they continue to work past age 70 ½.
6. Can contributions be made to an IRA for a non-working spouse?
Yes, they can, assuming you are filing a joint return for the year. The IRA must be in the name of the non-working spouse and is deductible from income the same way any other qualifying traditional IRA would be. Here’s the story with how much you can contribute from a 2008 standpoint:
•The dollar limit is determined by the IRS. It is 5,000 this year or 6,000 if over age 50.
•The amount could be less if working spouse made any sort of deductible or non-deductible IRA contributions or if the working spouse made contributions to a Roth IRA.
If you have any other questions regarding IRA or 401k rollover accounts, feel free to e-mail me or call. There are countless financial planning topics which overlap with this discussion.*
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New York, NY 10022
P: 212-752-4343 *31
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
*It’s always a good idea to consult with your tax and other financial professionals prior to making IRA contributions and other decisions regarding qualified retirement plans.