Avoiding Taxes When Leaving an Employer’s Retirement Plan
Taxes on retirement income and earnings are generally deferred until you start drawing money out in retirement — but what happens to retirement plan money if you simply change jobs?
Worst-case scenario: In addition to the ordinary income taxes due on money you receive from your former employer’s retirement plan, you could be required to pay a 10 percent penalty if you’re under 59 1/2.
However, if you play your cards right, you can avoid this penalty altogether and defer taxes until retirement.
The key is to make a rollover to another qualified retirement plan within the 60-day window allowed by the IRS. The following are some specifics on what this might entail for a pension or a 401(k) withdrawal.
Avoiding taxes on pension plan distributions
A pension is a retirement plan that promises to pay you specific benefits based on your earnings and length of service with an organization.
Are you vested?
The first thing to determine is whether or not your benefits are vested. Often, eligibility for benefits depends on serving with the organization for minimum time period and, if you leave before that time, some or all of your benefits will be forfeited.
If you are vested, can you leave your money in the pension plan when you change jobs?
If you are entitled to vested pension benefits, you will probably have two choices. In some cases, you can choose to leave your money in the pension plan and receive your benefits as scheduled upon retirement. In that case, there should be no issues with taxation until you start receiving those benefits.
Do you have to leave the plan when you change jobs? Often, a pension will require you to:
1. Leave the plan when you leave the sponsoring employer, and
2. accept a lump-sum payment in lieu of retirement benefits. This lump-sum payment must be handled correctly to avoid incurring immediate taxes and penalties.
You can continue to defer taxes if you roll that money into a qualified retirement vehicle, such as an employer-sponsored retirement plan or a traditional IRA, within 60 days. It is generally most efficient if you can get the money transferred directly from the pension plan into another qualified plan rather than receiving the money personally and then depositing it in the new plan later.
Cashing out a 401(k) after leaving a job
When it comes to cashing out a 401(k) after leaving a job, what you are entitled to is based on the current market value of your 401(k) balance.
In some rare cases, you might be able to leave that balance in the 401(k) plan after you change jobs, at least for a period of time. Most often, though, you will have to take that balance with you when you leave. This 401(k) withdrawal could subject you to taxes and the 10 percent penalty if it is not handled correctly.
To avoid taxes and the early withdrawal penalty, you must roll your 401(k) balance into another qualified plan within 60 days. You may be able to roll that money into a 401(k) plan at a new employer; but if that is not available, you can roll it into a traditional IRA instead. Here again, it is best to arrange for a direct rollover from the old plan if possible.
Plan ahead to smooth the way
Because there is a limited amount of time involved — and possibly a significant amount of money at stake — if possible, plan ahead about how to handle your pension or 401(k) withdrawals before leaving an employer.
Can you remain in the plan?
Find out if there are any provisions for remaining within the plan, or what the grace period is (if any) before you have to take your money out. If you have a new employer lined up and they have a retirement plan, talk to their benefits office about whether that plan can accept rollovers.
Do you have to withdraw your funds?
If you cannot simply roll money from your previous employer’s plan into a new employer’s plan, you can still avoid taxes by setting up an IRA rollover. Just remember, though — the 60-day clock is ticking, so don’t delay.
Frequently Asked Questions
Q: When I retire, I will have two options for receiving money from my pension: $10,000 a month for life or a $2 million lump sum distribution. Which is better?
A: the right answer might be different for two different people, even if they were entitled to the same choice of benefits.
Crunching the numbers: lump-sum vs. monthly pension
First the numbers. Simple math tells you that your $10,000 monthly distribution would total the equivalent of the $2 million lump sum option in 200 months, or 16 2/3 years. However, money received in the future is less valuable than money received today. You could use a broker to invest and grow money received immediately, while money received at some future date is likely to have its value eroded by inflation.
For these reasons, future amounts are often discounted to calculate their equivalent present value. For example, using the fairly risk-free 2.70 yield on a 10-year Treasury instrument to discount the option of $10,000 in future monthly pension income suggests it would actually take nearly 265 months (i.e., 22 years and one month) for those future cash flows to have the equivalent value of $2 million received today.
Other considerations for retirement income vs. lump-sum distribution
Based on this calculation, 22 years and one month is the breakeven point for deciding whether the lump-sum distribution is more valuable than the potential monthly pension income. Given the numbers that you have provided, and assuming there is no cost-of-living adjustment to your monthly pension income, the monthly option would be more valuable if you expect to continue to receive it for at least 22 years and one month.
Here are things to consider as you evaluate that possibility:
- Your age/life expectancy. Your age and your health should factor heavily into your assessment of whether you are likely to live long enough to receive over 22 years of monthly pension payments.
- Survivor benefits. If your plan has provisions for your spouse or children to continue receiving some portion or all of your monthly distribution amounts after you die, it could substantially increase the total value of those future payments.
- Your comfort with making investment decisions. Taking the lump sum means you are responsible for deciding how to invest it and how to budget spending from it. If you are not comfortable with that kind of responsibility, you might prefer the monthly income option.
- Your confidence in the pension’s funding. If you choose the monthly retirement income option, you are counting on the pension being solvent long enough to continue making those payments many years into the future. Before assuming that, do some research into the pension’s funding status and the long-term viability of the company. While the Pension Benefit Guaranty Corporation, a U.S. government agency, guarantees pension benefits to some degree, there are limits that could affect the amount of your future distributions if your plan runs into financial difficulty.
Whichever option you choose, remember that retirement can last a long time and that brings some uncertainty into play no matter whether you fund it with a lump sum or monthly pension income. Be sure to avoid common budget mistakes to make the most of whatever resources you have to fund your retirement.
Q: I receive $1,670 monthly from a pension, and have been given the option of receiving a lump sum instead. How could I invest that lump sum to get the same amount of income for my monthly expenses?
A: The crucial piece of information here would be how big the lump sum is. But even without getting that specific, it is worth reviewing some of the issues involved in this decision so you’ll know what to consider.
A significant problem with taking a lump sum over a guaranteed income stream these days is that it’s hard to generate much guaranteed income on your own. According to the FDIC, rates on savings accounts average just 6 basis points, and even five-year CDs average just 74 basis points. The most competitive savings account rates listed on MoneyRates.com are up around 1 percent, while the best CD rates are at around 2 percent for a five-year term.
At 2 percent, you would need slightly more than a million dollars to produce $1,670 in monthly income. Chances are, the lump sum you are being offered is nowhere near that amount, because conceptually your future monthly payments are supposed to be substituted by a combination of the principal of the lump sum plus its potential earning power, and not just the earning power. In other words, you would likely have to draw the principal down over time, which brings up another important issue: longevity risk.
Longevity risk is the financial uncertainty that stems from not knowing how long you will live. If it turns out that you live a long life, you may well get more out of the monthly pension. On the other hand, if you have relatively few years left, then a lump sum might be more rewarding because you would get your money up front. Your current age and health are obvious factors in this decision, but so is the issue of whether the pension has spousal benefits. If a surviving spouse would continue to receive pension benefits, that adds more to the potential future value of continuing to receive monthly payments over a lump sum.
You assume responsibility for a number of uncertainties if you take a lump sum, though one thing you wouldn’t have to worry about is the future financial condition of the plan sponsor. If that plan sponsor falls on hard times, it could jeopardize the future funding status of the pension plan. However, if you don’t think that will be a problem, you may want to stick with the certainty of those monthly payments, unless the amount being offered via the lump sum is extremely generous.
