Ted's Table

June 6, 2000

This Week, Ted Tackles: Clarification of after-tax withdrawal rules ... Can I withdraw my 401(k) money to buy a second home? ... Does the early withdrawal penalty apply to 401(k) money with former employers? ... How does the "same desk rule" work? ... What recourse do I have when my employer moves my money to a fund that does badly? ... Will returning to work after retiring at age 55 trigger the early withdrawal penalty?

TB: You're correct that after-tax contributions made before 1985 are treated differently than after-tax contributions made after 1985. You're permitted to withdraw the pre-1985 after-tax contributions without having to withdraw any of the taxable portion of your account. This is why these contributions are shown separately on your statement. Thanks for the reminder.

Question: We're considering purchasing a second home to use for retirement. The total account balance in my two 401(k)s is approximately $55,000. We'd like to keep our present home, sell it in a couple of years, and use that money for retirement. Using the 401(k) money now would substantially reduce our house payments and allow us to be able to afford them after retirement.

If we withdrew that money now, what would we pay in taxes? Does this plan seem reasonable to you? By the way, why is there a penalty tax (before 59ý) if we've lost money in the stock market in the 401(k)? That doesn't seem right.

TB: For starters, you probably won't be able to withdraw the money from your 401(k) for this purpose if these are pre-tax contributions. Such contributions may be withdrawn prior to age 59ý, while you are still employed by this company, only for IRS-approved financial hardships. One of the IRS-permitted reasons is the purchase of a primary residence. This won't be your primary residence at the time you purchase it; therefore, you shouldn't be permitted to make a withdrawal. Your other questions will be irrelevant if you can't withdraw the money but I will answer them anyway.

Any withdrawal prior to age 59ý, while you're still employed by the company that maintains the 401(k) where your money is invested, is fully taxable, plus a 10 percent penalty tax will also apply. Probably at least 30 percent of any amount withdrawn would be lost in taxes. Incurring this tax hit so that the payments on the second home will be lower doesn't make a lot of sense to me.

I don't recommend buying the second home now if you have to withdraw money from your 401(k) to do so. Real estate can become illiquid, meaning you can't always sell it at the price you would like when you want. It took me several years to sell our home the last time the real-estate market tanked. Depleting your retirement savings in order to own two homes isn't a good idea unless you will have other funds to live on when you retire. I recommend keeping your money in the 401(k) and delaying purchasing your retirement home until after you retire and have an offer on your present home.

Concerning your last question, the amount you withdraw from your 401(k) will ultimately be taxable. The best time to withdraw it is after you retire and have little or no other taxable income. You have been contributing to your 401(k) for a number of years if you have accumulated $55,000. In all likelihood, the amount you have accumulated exceeds the amount you have contributed despite the recent drop in stock prices. However, even if the value of your account is less than the amount you have contributed, withdrawals are fully taxed because no tax has ever been paid on any of this money.

Question: I have two 401(k)s from previous employers. I understand that if I withdrew from my 401(k) at my current employer I would pay 20 percent in income taxes plus a 10 percent penalty fee. Does the 10 percent also apply to 401(k)s with previous employers. I am 54 years old.

TB: The same tax rules apply to withdrawals from you current and prior employers' plans. Because you left the prior employers before you attained age 55, any amount you withdraw prior to age 59ý will be fully taxable, as additional income and the 10 percent penalty tax will be imposed. The only way to avoid the 10 percent penalty tax, if you want to withdraw money now, is by taking it as an annuity income stream, if the plans permit this type of distribution.

Question: My division is being outsourced to another company and I'm not certain if the human resources department is being honest with us about our options. They claim we fall under the "same desk rule" in which we would have only two options with our 401(k) plan. They are: (1) Transfer pre-tax contributions and earnings to our new employer's plan, OR (2) Leave the 401(k) funds with the old employer, which will remain there until terminating employment with the new employer.

Do we really have only these two options with our 401(k) funds? If yes, what's odd is: (1) Although we all are being fully vested in our 401(k) regardless of years of service, vesting rules for our cash balance pension remains the same. We aren't all vested. (2) We don't have the option to transfer our 401(k) into a rollover IRA — EXCEPT — if we do a pre-tax transfer to our new employer. Then we would be eligible to receive a distribution of the remaining 401(k) balance, i.e., company contributions and earnings, earnings on after-tax contributions, and any previous rollover amounts may be eligible for a rollover to an IRA or the new company's 401(k) plan (after-tax contributions would be sent to us as a separate check). Are they allowed to do this to us (allow transfer of OTHER funds ONLY if pre-tax contributions are transferred to a new employer and not allow us to move the pre-tax contributions to a rollover IRA)?

TB: I can understand why you are questioning the information you have been given. It must seem strange that you can withdraw the company contributions after they are transferred to the new plan but you can't withdraw your pre-tax contributions. This is correct because the law and IRS regulations make it more difficult to withdraw your pre-tax contributions than the employer contributions while you are still employed.

The IRS has recently softened its position on the "same desk rule" in cases where the assets were sold for cash and comprised less than 85 percent of the selling company's assets. You should ask your HR department whether this change has been considered. The two options you have been given with respect to the pre-tax contributions are correct unless the recent IRS change can be applied to your situation.

Question: My question concerns a strange thing with my wife's 401(k). We had it invested in one fund, and apparently they decided to drop that fund from the plan. They switched our money from one fund to another, supposedly similar, fund without our knowledge. As luck would have it, it has been pounded particularly hard since she left in March. Can they rightfully do this?

TB: The issue you raise is a very interesting one. Employees are constantly told that managing the 401(k) money is their responsibility. They must decide how to invest the money and accept full responsibility for the results. Then the employer decides to change funds without consulting the participants. Participants suddenly find their money has been moved to a new fund or funds without their approval. When this happens, I'm frequently asked, "how can the employer do this if investing is my responsibility?" The answer is that the employer can change funds without consulting the participants and they frequently do so for a variety of reasons. There clearly is an interesting contradiction here, which I have been speaking about recently at industry conferences.

Question: I'm 55 and considering retirement very soon. I intend to combine my pension-plan lump sum with my 401(k), leaving the total in my current 401(k) account. I also intend to find work to supplement my retirement. Would my work plans threaten the non-penalty status of tapping into a 401(k) at age 55?

TB: Continuing to work after age 55 won't impact your right to tap into your 401(k) funds without triggering the penalty tax, as long as you are not working for the company that maintains the 401(k) where your money is held. You may work for any other company, either part or full time, without impacting your eligibility to withdraw these funds without penalty. You could even return to work with the same employer after the distribution has been reported to the IRS.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every Tuesday. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, 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.

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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.