Employee benefit retirement and distribution planning is in regards to Qualified Retirement Plans such as 401k or 403b, 457, Roth 401k, Roth 403b, and how they interact with IRA’s. It is easy to get into a tax trap with these. For example, if you borrow from a 401k you must pay your account interest which is usually not tax deductible, yet when you retire and get a distribution then you are taxed on the interest that you paid to yourself. Thus 401k’s used improperly can create a tax trap. Also, using a 401k loan stops you from contributing, thus your true cost of a 401k loan would include loss of the company match and loss of the use of a safe haven to have long term tax deferral. There are tax rules that restrict above average earners from contributing to an IRA if they also are deemed to be a participant in a 401k, even though it may appear they are not a participant, there are subtle reasons that one can be “deemed” by IRS to be a participant. Another tax surprise is that the highest paid employees are not allowed to contribute the full amount of the 401k contribution amount if the low income employees fail to participate in the 401k.

Special rules apply for 403b participants with over 15 years on the job. Careful financial planning needs to be done to integrate the client’s needs for liquidity kept outside of a Qualified retirement account (for emergency spending, etc.) while still following a goal of building up a tax-deferred retirement account. Employee benefit retirement and distribution planning needs to examine this issue.

For clients with a significant net worth, it may be a mistake to build up a 401k or IRA because the combination of estate tax and income tax on those is about 75%. If you are retired and have a net worth large enough to be concerned with estate tax then you may not want your heirs to inherit an IRA or a 401k; instead you may want to explore charitable giving or simply spend down the proceeds while you are alive so that your estate will pay less estate tax. This is an example of how financial planning including Employee benefit retirement and distribution planning must be custom tailored for each client and the various topics of financial planning must be integrated with each other.

401k qualified retirement plans can be rolled over to an IRA when someone changes jobs or retires. In some cases employers permit a 401k to be rolled over to an IRA while you are still employed with that employer. That is called an “in-service distribution”. Generally speaking it is better to rollover a 401k to an IRA because you have more freedom to invest and you have more control and better service in terms of estate planning details. Also, if you keep several 401k’s this can get confusing because each employer has different rules and different investment choices. Employee benefit retirement and distribution planning should take this matter into account.

However, there are reasons to keep a 401k. You can borrow from a 401k, but not from an IRA. 401k plans at large employers can sometimes access low cost “I” class mutual funds that are not available to retail consumers. If you terminate employment after the year you turn age 55 you can get a distribution (not a loan) from a 401k with no early withdrawal penalty, but for IRA’s you must wait till age 59.5 to make a withdrawal that is free of penalty. So if you will turn 55 in December, 2010, and if your employment ends in January, 2010, when you are 54.1 years old, then 401k distributions (withdrawals) are penalty free. This is a rather attractive employee benefit feature. Of course, you still pay the regular income tax. 401K rollovers can not be reversed back out of an IRA and into the 401k, unless someone becomes re-employed at their old job, and not all employers allow rolling of an IRA into a 401k. This means you should get careful tax planning and retirement planning to see what is the best strategy. Tax and retirement planning needs to be integrated with investment planning. For example, the investments in the 401k need to be coordinated with those in the IRA and in the taxable account, plus cash flow needs for retirement need to be planned for and cash for emergencies need to be set aside.

Whenever you transfer money from a 401k to an IRA or vice versa always tell the Custodian to do a “Custodian-to-Custodian” transfer. It is best to do this using the same Custodian for both the old and new account. Once the funds have been rolled into an IRA then later you can do another Custodian to Custodian transfer to another IRA Custodian if you don’t like the first one. Also. tell the old Custodian to be sure to structure the transfer as one that will have no tax withholding. Make sure the new Custodian puts the funds into a tax qualified retirement account such as an IRA or 401k.

Beware of a tax trap: when rolling a 401k to an IRA, before doing so check to see if you have an Net Unrealized Appreciation (NUA). Special rules apply that, if not followed, create an irreversible tax trap. This is why it is important to get integrated financial planning, including employee benefit retirement and distribution planning.

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Donald Martin is a NAPFA-Registered Fee-Only financial planner and investment advisor.