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By: Ted Benna Creator of the first 401(k) plan |
June 6, 2002
This Week, Ted Tackles:
Can I roll my 401(k) into a SEP or Keogh? If I reenter the corporate world can I roll this back into a 401(k)? ý How does the change to the same-desk rule this year affect qualified plans? ý I want to make a lump-sum contribution to my 401(k) to meet the $11,000 annual limit. What is the law on this? ý If I retire, what are the tax rules concerning company stock? What if I want to sell shares over time?
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Q: I am currently fully vested in my employer's 401(k).
I plan to leave the company and start my own business. I am aware of the various
self-employed retirement savings vehicles such as SEPs and Keoghs. Can I roll over my
401(k) into one of these types of plans or do I have to roll it over into a traditional
IRA? I may return to the corporate world after trying to run my own business. Can I then
transfer this money back into a new employer's 401(k)?
TB: The tax law passed in the summer of 2001
contained new rules allowing you to roll your 401(k) money into a self-employed plan and
then transfer this account to another 401(k) plan at some future point.
As you probably know, a Keogh plan, which is a qualified
retirement plan for small businesses, is available only to non-incorporated businesses. A
SEP, which stands for Simplified Employee Pension, is available to both incorporated and
non-incorporated businesses. Other plans to think about include: a SIMPLE IRA, a
profit-sharing plan or a one-person 401(k) that is offered by some providers.
The steps you should take are to first open the plan of
your choice and then ask your former employer for a direct transfer of your entire 401(k)
balance to this account. By making a direct transfer you will avoid the 20 percent
mandatory tax withholding, and the early withdrawal penalty if applicable.
Q: How does the repeal of the same-desk rule work with
qualified plans? Do the plan documents have to be updated for that change? Can I take a
withdrawal from a company plan that was taken over before the rule was changed?
TB: For the benefit of our readers not familiar with
this topic, here's a quick explanation of the same-desk rule. It states that if your
division was sold to a new employer and you essentially continued doing the same job,
"at the same desk," this did not count as changing employers (which normally
would allow you to access your 401(k) money). You were not allowed to withdraw or roll
your money into a new plan unless you left your job or qualified for a hardship
withdrawal.
You are correct that the same-desk rule was repealed
effective Jan. 1, 2002. The new rule permits distributions upon "severance of
employment" and it governs distributions made after Jan. 1, 2002 regardless of the
date of actual severance of employment. Sale of a division to a new employer counts as
"severance of employment" providing the employee totally terminates his
relationship with the previous employer and any related entities.
Although the law has changed, employers may retain the
same-desk rule. Employers are also still permitted to transfer employees' 401(k) money
(the amount accumulated before the sale of the business) directly to a successor
employer's plan, without participant approval.
Bottom line, employers still must decide what to do but
they must follow the provisions of the plan document. The model EGTRRA amendment that
Treasury issued at the end of last year includes the repeal of the same-desk rule, but
each employer must adopt this or a similar amendment before such distributions are
permissible.
Q: If I leave my employer may I take my company stock in
the form of shares? Do the shares have to go into a rollover IRA? If you can and do take
shares and don't put them in a rollover, what are the tax implications? What if you sell
the shares over time, say three to five years?
TB: You may take the company stock as shares of
stock if you leave your employer. You can either roll them into an IRA (using a brokerage
company that handles IRAs that let you own individual stocks) or retain them outside an
IRA. The tax implications are different for each option.
Your first decision should be whether to retain the shares
of company stock or sell them and diversify your holdings. If you plan to retain the
shares, it probably doesn't make sense to transfer them to an IRA for reasons I'll explain
in a minute. You should think about whether you will need to sell the stock to survive. If
you'll need the money to meet your retirement income needs, you might want to seek greater
security in your investments. You can greatly reduce your investment risk by selling the
stock within your 401(k), transferring your entire benefit as cash directly to an IRA, and
then properly diversifying your investments. There is no tax implication for doing this
because it is a rollover; however, you will pay income tax on your eventual distributions
from the IRA.
If you retain the shares rather than selling them, you get
a special tax break if you don't roll them into an IRA. Here's how it works. When you
receive the stock outside an IRA, you pay income tax based on the stock's value when it
was contributed to the plan, provided that is less than the current market value. You only
pay tax on the gain beyond that when you sell the stock, and then it will be taxed as a
capital gain, which is usually a lower rate than the income tax rate. You can sell as many
shares as you want, whenever you want, if you hold the stock outside an IRA. You will pay
capital gains tax on the shares you sell during the year you sell them. This tax will be
computed on the difference between the value when you received the stock in the plan (your
cost basis) and the value when you sell it.
Assume your company stock is currently worth $100,000 and
the value when you received it was $20,000. The $20,000 acquisition value will be taxable
as income when you receive the stock, providing you don't roll it over into an IRA. The
organization that administers the plan is required to provide you with the acquisition
value (cost basis). You will have to sell enough shares to cover the tax liability or use
other money to pay this tax. Once you have done that, when you sell the shares you will
only pay capital gains tax on the gain.
There is one additional tax benefit that I should mention.
If you retain the stock outside an IRA until you die, your heirs will never have to pay
tax on the gain that occurred from the time the stock was acquired in the plan until the
time of your death. The tax base for your heirs will be the market value of the stock when
they receive it. Assume you retain all shares of the stock and they are worth $250,000 at
the time of your death. Your heirs will not have to pay any capital gains tax on the gains
that occurred prior to your death. This is a big tax advantage, but having all this money
invested in a single stock is risky.
If you put the shares into an IRA, you lose these tax
breaks. When you sell the shares in order to take a distribution from the IRA, the
distribution will be taxed as ordinary income. You end up paying income tax on the entire
value of the stock sold rather than paying income tax only on the cost basis, and (lower)
capital gains tax on the gain. What's more, if you're less than 59 1/2 years old when you
withdraw the money from the IRA old you'll owe a 10 percent penalty tax unless you take
periodic distributions that qualify under Section 72(t) of the Internal Revenue Code.
I recommend consulting a qualified professional advisor if
you have a lot of stock, to help sort out your options.
Q: If I wanted to make a lump-sum payment this month so
that I could meet the annual limit of $11,000, can I do this? The 401(k) managers at my
employer claim that I have no means of doing this. What's the law?
TB: You may be able to make an $11,000 lump sum
payment, but you have to earn more than $11,000 a month to do that. The reason is that you
fund 401(k) contributions out of pretax earned income. The money comes out of your
paycheck.
Also don't forget that you will need to earn enough to
cover your other paycheck withholding obligations such as Social Security and health
insurance.
Additionally, your contributions may be limited if your
employer imposes a percent-of-pay limit on contributions. This may be the reason why your
employer said you can't make this contribution. I suspect that historically, your employer
probably limited your contributions to a maximum of 15 percent to 20 percent of pay prior
to this year. (Currently, I recommend to employers that they set the maximum employee
contribution limit at 75 percent of pay. That way employees can make as large a
contribution as possible and retain enough income to cover their other payroll
deductions.)
Bottom line, if the stars and moon aligned, you could make
the contribution.
I know of some employees who do make a lump-sum
contribution for the full annual limit when they receive their annual bonus.
A word of caution -- front-loading your contribution will
cost you money if your employer matches your contributions only during pay periods when
you are contributing to the plan. The employer match will stop in this instance when you
stop contributing. I recommend contributing a lower percentage if this is how your plan
works, so you can get the match for the entire year.
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Ted Benna, creator of the first 401(k)
retirement savings plan, answers intriguing questions twice a month. With over 40 years of
experience as an employee benefits consultant, Ted is a nationally recognized expert on
benefits issues. He has authored three books, Helping Employees Achieve Retirement
Income Security, Escaping the Coming Retirement Crisis, and Tips for
Successfully Managing Your 401(k), and is President of the 401(k) Association. Ted is
a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and
comments have appeared in numerous publications, including The New York Times and The
Wall Street Journal. |
 Ted's Table Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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