The Experts

Ask the Expert

By: Ted Benna Creator of the first 401(k) plan

August 15, 2002

This Week, Ted Tackles:
I'm highly compensated and was told my 401(k) contributions are being capped. How can I contribute more? ı Can I take a hardship withdrawal from my plan in order to pay off credit cards? ı I hold some stock in an old 401(k) plan. How can I roll this into a new plan? ı My husband withdrew 401(k) money to pay medical bills, but the account's balance was less than the amount he contributed. Can we take the loss off of our taxes?

Q: I am a highly compensated employee and just received a letter from my employer saying that my 401(k) contributions will be suspended in about two weeks, when I reach the approximately $8,000 year-to-date limit mandated by the plan's nondiscrimination testing. My employer said it hopes to allow further contributions later in the year.

Is there anything in the "catch-up" provisions (or anything else) that would allow me to continue contributing up to $11,000? I turned 44 in May.

TB: The new catch-up contribution, $1,000 this year, isn't included in the non-discrimination tests. However, this won't help you because only employees who are at least 50 years old may make these contributions.

Unfortunately, it sounds like $8,000 is the most you may contribute before taxes unless your employer also has a separate nonqualified plan. Most major employers have these plans, which permit senior executives and other highly paid employees to make up the benefits that can't be provided through the qualified plans (such as 401(k)s) that cover other employees. You should ask your employer if it offers such a plan.

Other possibilities are to make a nondeductible contribution to a traditional IRA, or to open a Roth IRA if you are eligible to do so. Your contributions to these plans are made with after-tax income, but your investments grow tax-deferred. Further, with the Roth IRA you don't pay tax on the investment gains when you take withdrawals. mPower Cafe's Frequently Asked Questions section covering IRAs lists the income eligibility limits for Roth IRAs. You can find a link in the "Related Reading" sidebar.

Q: Because of recent circumstances, my husband and I can't afford to make our credit card payments anymore. He has about $25,000 saved in his 401(k), which covers over half the debt. Would paying off the credit cards be allowed under the hardship distribution rules?

Another option we thought of was to buy a house, using the $25,000 as a down payment, then a year later take a second mortgage and pay off the cards completely. Would the hardship distribution rules allow us to withdraw that much for a down payment on a $180,000 house? Do you know any other way that we could use the 401(k) to decrease our credit card debt? We understand that there will be a 10 percent penalty for anything we would do.

TB: Paying credit card debts isn't one of the acceptable reasons for withdrawing money from a 401(k). Yet, taking a hardship withdrawal when the intent is to use it to purchase a home is okay. You will, of course, have to pay the income tax plus the 10 percent early withdrawal penalty tax, which applies if your husband is younger than age 59 1/2.

You say you have $25,000 currently in the account. Let's assume you are in the 27.5 percent federal income tax bracket and your husband is younger than age 59 1/2. The federal taxes and penalties on this withdrawal would be $9,375, leaving you with $15,625. You might also have to pay state and local income taxes, which will further reduce this amount.

And there's one other thing to think about -- this will certainly put a huge dent in your retirement savings.

Unfortunately, most people who take action similar to what you are considering to pay off credit card debt end up back in the same position within one to two years. You should seriously consider addressing the real problem, which is proper financial management. There are organizations that help people develop budgets and to control compulsive spending. I strongly recommend getting help from one of them.

Q: If I want to roll an old 401(k) account into my current one, how is this done? Is the account liquidated and then transferred? In my old plan there was a self-directed investment option where you could transfer money to a separate account and purchase securities of your choice. Since the market went down I have a lot of losses and I am hoping for a recovery of some kind before selling.

TB: First you need to see whether your current employer will accept a rollover from another plan. Most plans will accept rollovers but they aren't required to do so.

Rollovers are usually accomplished by converting the assets (funds, stocks, etc.) from the old plan into cash and then transferring the cash to the new plan. Technically the assets can be transferred in kind (as shares of the funds or stock) but this is unusual because a lot more work is required to change the ownership of these funds and stocks from the trustee of the old plan to the new plan.

In addition, transferring the specific stocks that you hold will be possible only if your current employer has a similar self-directed account that permits stocks to be purchased under its plan. Bottom line: It is unlikely that a transfer of these stocks to your current employer's plan will be possible, but you should ask whether your current employer's plan would accept a transfer of these stocks anyway.

If a transfer of the stocks to your current 401(k) plan isn't possible, you should consider transferring the shares of these stocks directly to an IRA. This will be possible if the prior employer permits these shares to be transferred in kind. Ask before you proceed. If your former employer will permit the shares to be transferred, you should open an IRA with a brokerage firm that will accept the transfer of these shares. Then have the shares transferred directly from the prior plan to the IRA.

If your prior employer will permit only cash distributions, then the only way to retain the shares is to sell what you have and repurchase the shares after the cash has been transferred to an IRA held by a firm that will permit stock purchases. This will enable you to retain the stocks you have, but, unfortunately, you will have to incur the cost of selling and repurchasing them. Hopefully the time between liquidation and repurchase will be short, and the market relatively calm, so that you can repurchase the shares at a price close to the selling price.

Q: My husband withdrew the funds in his 401(k) last year to pay off large medical expenses. We paid the required federal and state taxes and penalties. Since the 401(k) balance that we withdrew was a much lower amount (due to market losses) than what he originally contributed, is there any way to recoup some of those losses? Can the taxes be reduced because we paid more into the 401(k) than we were able to cash out?

TB: Sorry, but there isn't any way to do what you are asking.

The reason is that your husband didn't pay any income taxes on the money when it was put into the plan. When he withdrew money, he was required to pay income tax on the amount that he actually withdrew. In effect, this resulted in a "tax break" because he paid tax on a reduced value.

For example, assume he contributed $5,000 to the plan but due to investment losses, the account was worth only $4,000 when he made a withdrawal. Remember that he hasn't paid any income taxes on the $5,000 contributed to the plan. His only tax obligation was on the $4,000 that was withdrawn.

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.

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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.