Early Retirement and Your 401(k) Choices

By Diahann Lassus, CFP®, CPA
Jul 3, 2001 12:50 PM

You have just signed the papers to accept an "early-out" offer from your company. You are going through your checklist of things to deal with and run across your 401(k) form. You have been really good at contributing and have accumulated a significant amount of money in your account and now you have many choices about how you handle these dollars, and you don't want to make a mistake. You know that this decision is a really important one and will have a significant impact on your financial health.

Here are your basic choices and some of the advantages and disadvantages:

1. Leave the dollars in the company 401(k) plan for some period of time Generally requires no action and continues tax-deferral Avoids current taxes and potential penalties incurred on withdrawal After-tax contributions continue to build tax-deferred Can begin distributions when you leave the company if you are age 55 or older Investment options may be limited Distribution choices may be limited

2. Roll the eligible dollars into an IRA account at a brokerage firm or mutual fund family.

  • Maintains tax-deferral of dollars
  • Avoids current taxes and potential penalties
  • Expands your options for investment choices
  • May increase your flexibility in terms of how you take distributions
  • New tax rules allow you to rollover after-tax contributions beginning in 2002
  • May increase your cost if an advisor is needed
  • May be subject to 10 percent penalty for early withdrawal if you are under age 59 1/2

    3. Roll the dollars into another 401(k) plan with your new company

  • Maintains tax-deferral of dollars
  • Avoids current taxes and potential penalties
  • May limit your investment choices

    4. Take a lump sum distribution of cash or an in-kind distribution of stock

  • Offers immediate access to cash
  • May allow you to utilize special tax strategies if you are eligible
  • Eliminates tax-deferral of investment growth
  • Subjects dollars to applicable federal, state and local income taxes
  • Potentially subjects you to a 10% penalty for early withdrawal

    Where do you start? The first step is to do nothing until you understand all of your choices and what they mean to you. Do not allow yourself to be pressured into making a decision before you understand all of your options. The second step is to make your 401(k) decision part of your overall financial and investment plan and not an independent decision.

    You need to answer some basic questions for yourself before starting this decision process. At what point will you need to use these funds? If you don't need them for the next five years or more, you have more flexibility in your choices. If you need to begin using these dollars soon, your choices may be more restricted. Here are some recommendations for going forward:

    • Leave the dollars in your 401(k) until you have a plan. If you have not been handling investments through IRAs or other accounts and have no idea how to invest these dollars, leave it there for a while. Give yourself time to think through the alternatives.
    • If the 401(k) choices in your plan are good and they have performed well, it may make sense for you to leave it for a year or more. This gives you time to really understand how these dollars fit your overall plan and assure a smooth transition. If the investments have not performed well or you have very limited choices of investment, you may want to consider one of the other alternatives.
    • Roll it over to an IRA. This option may provide more choices for investment. This is the better choice if your employer 401(k) doesn't have a great assortment of investment options. IRAs also give you more flexibility in how you take distributions when you are ready to begin using these dollars. You may incur other costs including fees from an advisor and/or commission costs. Company 401(k)'s have those costs but they may be spread over large dollars and may be a smaller percentage. They are normally not very visible to most participants. There are changes in the new tax law that will allow the rollover of after-tax contributions beginning in 2002. This is a really positive change and increases the viability of Rollover IRAs for many individuals.
    • Take a lump sum in cash or an in-kind distribution of stock from the 401(k). I would advise not to consider this alternative without speaking to an advisor who is well-versed in tax law. If you are not 59 1/2 you will not only be liable for income taxes but may also be liable for a 10% penalty for early withdrawal. This choice allows you to take out company stock and convert some of the tax liability to capital gain over time. Some advisors are recommending this for individuals who own a lot of company stock in their 401(k) when the stock has lost a lot of value. I caution individuals that this assumes that you want to continue to hold this stock and that it will, in fact, appreciate significantly in the future. If it does, the future appreciation is taxed at capital gains rates rather than normal income tax rates. One of the "major" problems with this scenario is that it takes away the ability to continue to build these dollars on a tax-deferred basis. If the individual is young, these could be significant dollars. The other "issue" is that if the stock does not recover - the individual could lose even more of what was earmarked as retirement dollars.
    • The last choice is to transfer the dollars to your new Company's 401(k) if you choose to continue to work. The choice of whether to transfer to the new 401(k) or to an IRA should be based upon the investment choices available through your new company and what your overall objective is for these dollars. Transferring to the new company 401(k) may be easier because it defines the investment choices in a more limited way. It may not be the best choice if the investment selections are not very broad or if the funds have not performed well compared to other mutual funds available outside of the plan.

    And whichever alternative you select in handling your 401(k) make sure you "update" your investment program to be in line with your "new" objectives.

    Think, define that vision, redefine your objectives and select the choice that will get you there!