In these challenging economic times, you may be considering taking a hardship withdrawal from your 401(k) plan. Here are some points to think about before you pull the trigger.

What is a hardship withdrawal?

When discussing 401(k) hardship withdrawals, we’re generally talking about withdrawing your own elective contributions to the plan. This means your pretax contributions and your Roth contributions to the plan. A hardship withdrawal generally can’t include any earnings on your contributions.

In order to qualify for a hardship withdrawal, you have to have an immediate and heavy financial need, and your withdrawal can’t exceed the amount necessary to meet that financial need (including any taxes and penalties resulting from the hardship withdrawal itself). But there’s an important restriction: you can’t take a hardship withdrawal at all until you’ve taken all other non-hardship distributions and loans available to you from the 401(k) plan, and any other deferred compensation plans maintained by your employer.

Plans have a number of ways of administering the hardship withdrawal rules, but most rely on a “safe harbor” rule that automatically treats the following as constituting an immediate and heavy financial need:

• Medical care expenses for you, your spouse and dependents, and your plan beneficiary

• Costs directly related to the purchase of your principal residence (but not mortgage payments)

• Payment of tuition, fees, and room and board expenses for up to the next 12 months of post-secondary education for you, your spouse and dependents, and your plan beneficiary

• Payments necessary to prevent eviction from your principal residence or foreclosure of your mortgage

• Payments of burial and funeral expenses for your parents, spouse and dependents, and your plan beneficiary • Expenses to repair casualty damages to your principal residence

Why you should think twice …

In general, you should take a hardship withdrawal from your 401(k) plan only as a last resort, for the following reasons:

• Hardship distributions are includible in your gross income except to the extent they consist of your own after-tax (including Roth) contributions to the plan.

• The taxable portion of your withdrawal will be subject to a 10% early distribution penalty unless you’re 59½ or another exception applies.

• If your plan uses the safe harbor rule described earlier, when you take a hardship withdrawal, you’ll be suspended from participating in the plan (and any other elective plan maintained by your employer) for at least six months.

• Unlike plan loans, you generally can’t pay a hardship withdrawal back to the plan. A hardship distribution permanently reduces your account balance, reducing the amount that can work for you on a taxfavored basis until you retire.

• You can’t roll a hardship distribution over to an IRA or another employer plan.

And keep in mind …

A 401(k) plan doesn’t have to allow hardship withdrawals at all. And if it does, the plan may limit the reasons that qualify as a hardship, or may limit the amount you can withdraw. Some plans may not permit hardship withdrawals that are based on the need of your plan beneficiary. And in some cases, the plan may require that you prove you have no other resources available to meet your hardship need.

Your 401(k) plan may also permit withdrawals of other amounts in your account–for example, your employer’s contributions to the plan– but these withdrawals may be subject to different rules.

You need to review your specific plan’s terms to see what options are available to you. Your plan’s withdrawal rules should be clearly described in the plan’s summary plan description (SPD). If you don’t have one, request it from your plan administrator, and discuss your options with your financial professional.

Unlike plan loans, you generally can’t pay a hardship withdrawal back to the plan. A hardship distribution permanently reduces your account balance, reducing the amount that can work for you on a tax-favored basis until you retire.

This is Part III in a series. If you have not read Part I and Part II, I would highly suggest first reading them in sequence.

Opening this final installment of the trouble with 401k retirement plans (and others like it) with a slice of financial history may not seem all that relevant but in a moment you’ll see why it’s pertinent.

Put a trivia whiz on Jeopardy, ask what the relevance of 1933’s Glass-Steagall Act was and they’ll most likely answer that it created the FDIC. While this is certainly accurate, a lesser known fact was that it also placed a clear division between banks, brokerages and insurance companies.

But since 1999 when the act was officially repealed, the lines between financial institutions are now overlapped and completely blurred. Because of the repeal, unbeknownst to many, the pursuit of market returns is no longer confined within the framework of brokerages but is now also available within the banking and insurance industries as well.

Why is this relevant?

Well, while all three industries now offer at least some form of access to the market, the characteristics of our money within the framework of the industry we select can be vastly different from one another.

Specifically, the characteristics I am referring to are:

• Taxes: when and how we pay them.
• Losses: how the account is protected, if at all.
• Fees: how costs are structured.

While no institution can control the returns we receive, we do have control over the above and when we exercise such control, the difference it can make to the amount of income we can expect to receive at retirement can be quite dramatic.

Let’s take a closer look.

THE EFFECT OF FEES

Ironically, out of all characteristics, fees often bear the least effect on the retirement income we receive but because the subject seems to attract the most media attention, I’ll start with it first.

Many of us have heard something to the effect, “if you lower your fees you’ll have more money for retirement,” and there’s no doubt this is true. In fact, back in March, 2007, it was well documented in congressional testimony (see end footnote) that showed during the course of accumulating money and distributing it over a retirement, a lower fee would result in a higher compounding rate that could provide well over $500,000 more money to the individual; an amount that is certainly nothing to sneeze at.

But how can one possibly lower fees inside a retirement plan? The answer we often hear from the likes of Warren Buffet and a long list of other sources is to invest in the indexes rather than having professionals pick stocks for us inside the structure of a mutual fund or typical brokerage accounts. Not only would indexing significantly lower the fees, but it would also likely increase the performance of the account as well.

For example, the testimony above cited that “the S&P 500 index consistently outperformed 98 percent of fund managers over the past 3 years, 97 percent over the past 10 years and 94 percent over the past 30 years.” As for costs, “since index funds do no research and little trading, the costs of holding their portfolios are extremely small, some ranging as low as .10 percent a year.”

So, why do nearly all retirement plans fail to offer index investments? The answer, as stated in the testimony, is that the plans “are guided to particular decisions by non-fiduciaries in pursuit of compensations which very frequently is in the form of hidden and excessive fees.”

In a vacuum there is therefore little doubt that indexing would be the optimal choice in terms of lowering fees and increasing performance. But how likely is it that retirement plans will follow the advice of Buffet along with many others and offer these low cost indexes? Given the historical Wall Street and political landscape, the answer is very likely, “not much.”

As such, most people will continue paying the brokerage industry’s common percentage based fees that start off small but typically increase over time as the balance of the account rises, often peaking to its most expensive amount at the point just where it matters most: when we need to generate income from the account.

Most people will shift from accumulation into the distribution stage and continue to remain within the framework of the brokerage industry. At retirement, to try and minimize potential loss, individuals are often told to diversify their portfolio into a basket of stock and bond funds. While this will could very well help minimize loss, it will also serve to likely dilute returns as well.

If we assume average fees between 1.5 to 3 percent and one earns a conservative average of 6 percent, this translates into 30-50 percent of the earnings being lost just to pay the annual costs of the account itself.

Conversely, the insurance industry offers a variety of fee structures to choose from, two of which I want to address here:

• One can structure fees that generally remain level and fixed. These fees are based on the amount being contributed, not the account balance, so the effect is that over time, these fees get proportionately smaller in relation to the account balance. When compared to percentage based fees, a level fee structure could not only provide tax-free distributions but it is often at its lowest point when one needs to generate income from the account, thereby allowing an individual to realize more income instead of losing significant portions of it to fees. In fact, over the lifetime of an account, cumulative fees within this structure will often be considerably less costly than percentage based fees.

• One can also choose to eliminate management, transaction and maintenance fees. In this structure (as well as the above), there is no market risk to principal and in exchange, earnings are capped but at levels that have the potential to produce comparable long term average market returns commonly associated with the brokerage industry. After a period of at least ten years or more, eliminating fees will generally increase an account value by roughly 10 to 20 percent. Although relevant, the more pertinent point is that when in the distribution stage of retirement, this higher account balance can translate into a 50 to 75 percent increase in the amount of income over that of a traditional retirement plan nested within a brokerage account.

How so? Well, when taking distributions from the framework of the brokerage industry, if we assume a 7 percent average return less typical fees of 1.5 percent, this leaves earnings of 5.5 percent. To cushion against potential loss, the commonly referenced Withdrawal Rate states a person should withdraw no more than 4 percent of the account value per year. However, if one eliminates fees, earns the same 7 percent average return and has no possibility for market loss, most or all of these earnings can be taken for income, thereby increasing retirement income by a factor of 50 to 75 percent.

Bottom line: when in the distribution stage of retirement where percentage based fees are typically at their highest point, the proportionate effect of fees is far greater when compared to the effects during the accumulation stage.

THE EFFECT OF LOSS

As mentioned, a transition from the accumulation stage into the distribution stage commonly results in diversifying a brokerage account into stock and bond funds. Here, one might prudently follow “The Rule Of 100” which recommends subtracting one’s age from 100, resulting in the suggested percentage of stock exposure one should generally have in their portfolio.

While prudent in practice, market years such as 2008 were a disaster for both of these frequently suggested guidelines. With the exception of cash positions, in that year and others like it, just about everything went down in value; hence the reason the heavily scrutinized Withdrawal Rate understandably recommends taking no more than 4 percent of a brokerage account’s value for income. While earnings might exceed 4 percent, when an account is exposed to loss, one obviously needs to maintain a reserve for periods when losses occur.

But when an account is (a), protected from market loss, (b), fees are generally level or eliminated and (c), market returns are still possible, then one would not have to hold back earnings to cushion against market downturns; one could use most or all of the earnings for income, and this particular set of characteristics is available only within the insurance industry and is therefore the main reason I am focusing on it for this post.

In the insurance industry’s structure where they offer protection from market loss, if we assume an average return of 7 percent, then withdrawing anywhere between 6 and 7 percent equates to a 50 to 75 percent increase in income when compared to the brokerage industry/Withdrawal Rate’s recommended 4.

THE EFFECT OF TAX

While fees and protecting an account against market loss are of course quite important, the characteristics that will bear the most effect on our retirement income is by far taxation.

This is because year after year, taxes effect:

• The amount of income one actually gets to spend, and,
• The overall account value given that taxation causes the need to withdraw the gross amount of income which often exceeds the returns the account is actually earning.

For example, suppose one retires with $1,000,000 and the desired spendable income is $50,000. In a one-third tax bracket, one would have to withdraw roughly $75,000 to actually spend $50,000. If one diversifies their portfolio, receives an average return of 6 percent less 1.5 percent fees, the account can be out of money in approximately 20 years.

Furthermore, and something that is often not factored into this area of discussion: withdrawals from a traditional retirement account will likely expose one’s Social Security income benefits to taxation, up to the tune of 85 percent. While many focus on taxation issues regarding income taken from a taxable, brokerage retirement account, when factoring in indirect taxation, withdrawals from these retirement accounts can also cause increased taxes on Social Security income as well.

For example, if one withdraws $20,000 from a taxable retirement account, they would obviously be paying taxes on this full amount. In a one-third tax bracket, that would equate to approximately $6,000 owed in taxes. However, this income could also trigger 85 percent of the equivalent Social Security income to be exposed to taxation as well, resulting in an additional $5,000 – $6,000 that could be owed in taxes as well.

If, however, one eliminated the tax by utilizing the characteristics available within the insurance industry, they would only have to withdraw $50,000 from a $1,000,000 account earning 5 percent to actually spend the same amount. In this case, the balance of the account could have far greater longevity than that of a typical taxable brokerage retirement account. And finally, within this structure, Social Security income might not be exposed to taxation as a result of these withdrawals as well.

Eliminate the tax, and depending on one’s bracket, an individual can typically increase their income by 50 to 65 percent as well as potentially eliminate up to 85 percent of Social Security exposure to taxation as well.

It’s as simple as that.

CONCLUSION

If within the insurance industry one chooses to:

• Generally level out the fees, whereby costs are often at their lowest at the point of distribution,
• Eliminate the possibility of market loss, whereby one can withdraw most or all of the earnings for income, and,
• Eliminate the tax, it is therefore possible to potentially increase one’s retirement income by a factor of three times the amount when compared to distributing money from that of a taxable, brokerage retirement account such as a 401k, 403b, IRA and others.

Inversely, when utilizing the characteristics available within the insurance industry, one can potentially achieve the same results realized within the brokerage industry but with three times less the amount being contributed.

In summary, the choices we have when controlling taxes, losses and fees are highlighted below. Keep in mind, these results assume the same annual contributions ($16,500), the same market returns (7 percent), the same period of time, net of all fees and the shared mindset to preserve one’s account over a typical retirement:

After outlining the above, I am often asked, “should everyone utilize the insurance industry for their retirement?” My answer is always, “absolutely not.” One should never consider utilizing the insurance industry and its products for their retirement any more or less than they should consider utilizing the brokerage or banking industry.

Each industry and its products serves its own unique function and purpose, and only when one’s situation is well assessed and all facts are completely understood should any decision or approach ever be made.

That said, I often find there are gross misconceptions about the insurance industry, many of which are archaic in nature and based on outdated beliefs including, but not limited to, fee structures available and that the only access our money has to potential market returns is through the framework of the brokerage industry. The use of insurance policies and other products in a modified, suitable and legal manner that emphasizes living benefits takes an individual who thoroughly understands the new evolution of these products and designs the plans only in the best interest of the client and no one else.

Should you decide to pursue further investigation of this direction, I would highly advise speaking with someone who understands this new evolution of the insurance industry as well as someone who also understands the brokerage and banking industries as well. After all, what could be good for one person can be awful for another and only when one’s personal situation is well understood should a direction as important as one that relates to our retirement income (or any other matter) be made.

The sole intention of this three-part series has been to try and open the realm of possibilities many people don’t know exist that could help one realize a more peaceful, comfortable and prosperous retirement regardless of the path we select.  

‘1 Testimony of Matthew D. Hutcheson, “Congressional Testimony 401ks” US House of Representatives, March 6, 2007, p6

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

This is Part II in a series. If you have not read Part I, I would highly suggest reading that first.

In my last post, I discussed the trouble with qualified IRS retirement plans such as 401ks, IRAs, 403bs, SEPs, etc..  At its conclusion, I mentioned I’d continue this three-part series by addressing conventional solutions that claim will improve the results of these plans.

Before addressing them, I’d like to first begin with a brief recap of several important points:

• Most qualified plans were never meant to replace pensions, they were only meant to supplement them and that’s it.
• As a result, we are now being asked to retire on plans that even if funded and invested to perfection, they will leave many of us with completely inadequate retirement income.
• The contribution limits of these plans are low and restrictive.
• If one cannot make contributions, an individual is not permitted to make up for missed contributions in later years.
• Fees are typically quite high.
• Fund choices are limited and often below average.
• The value of the tax deductions one receives when making a contribution is often over estimated. In reality, the tax deduction one receives is actually a loan against future income whereas a true tax deduction is something that does not have to be paid back. Furthermore, it should be noted that the tax deduction is almost always spent rather than reinvested.

Conventional solutions that strive to improve upon these shortcomings typically revolve around discussions about the quality of the investments, fees and/or the amount being saved. However, I would like to begin by first focusing on the issue I consider of paramount importance and one that is often neglected: the issue of one’s behavioral mindset.

In the past, most people retired with a pension, and as basic as it may sound, it’s important to ask, “what exactly is a “pension?” It has nothing to do with the value of the account one has when they retire, rather, the pension is all about the income one receives.

Back in the seemingly ancient days of pensions, the retired individual didn’t know nor did they likely think much about the value of the account that was busy generating a lifetime of monthly retirement checks. Similarly, does anyone receiving Social Security really know or care about the value of the account generating their benefits? Not at all. Most people receiving Social Security are only concerned about the income they receive.

When it comes to retirement plans, however, today’s mindset is completely different: the primary focus is inverted. Given today’s age where pensions are basically extinct and the retirement plan is often the only account an individual has to carry them through retirement, the individual’s priority is most often focused not on the income the account will produce but rather on preserving its value as much as possible while taking out whatever amount of income it can support.

On the contrary, pension managers of the past had a distinct advantage over us. In the past, over a 30 year working career, the pension manager needed to set aside roughly 15% of an individual’s wages in order to provide them with 70% of their current income at retirement (60% if married). If the pension manager was faced with the additional burden of needing to preserve the account while generating the 70% target income, they would need to set aside not 15% of the wages but rather an astonishing 30%, which would have been a feat just short of impossible. As opposed to the behavioral mindset of today, the pension manager wasn’t required to preserve the account, rather, they would use the principal and its earnings in order to generate a reasonable income for the retired individual who statistics show will rarely do this for themselves given the mindset of preservation that exists today.

For most people, this might be a lot to comprehend but evidenced by the recent market disaster that prolonged many retirements, it’s critical for us to address these important points without delay.  After all, with rare exception, today’s individual is completely responsible for their own income at retirement and the need to take responsibility for this is a harsh reality most people need to face.

This leads me to the conventional solutions we often hear about that are said could increase a our chances for heightened retirement income success. Let’s take a closer look:

SAVE MORE

Some say one solution to generate more income at retirement is to simply save more money. Doing so would obviously increase the balance of an account at retirement and therefore the amount of income it can produce, but how many people can really save the 30-50% of their paycheck that would be necessary to produce a comparable amount of income that a pension would have provided?  The answer is, “not many.” Most people could never stash away 30-50% of their paycheck necessary to preserve their account while generating a comparable pension, so to me, this “solution” is really just a moot point.

WORK LONGER

Sure, working into one’s 70s or part time during retirement could obviously improve the amount of income one can expect to generate at retirement but unless voluntary, many people would simply not elect this path. While for many this might end up being their reality, it certainly wouldn’t be an optimal choice.

INCREASE THE RETURN

Betting on a higher return would certainly increase the account value at retirement and thereby the amount of income it can produce, but not only do we have no control over the return, most would agree the chances of sustaining a high return over a lengthy period of time is highly improbable. As such, when projecting how much an account will be worth at retirement and the amount of income it can produce, many would be far better off assuming a moderate rate of return and treat higher results as a welcomed plus rather than anticipating higher rates and regretting a lower return.

LOWER THE FEES

I often hear to better the end results of retirement plans, Wall Street and the third party administrators that oversee them should lower their fees. Given we have no direct control over this issue, while it certainly sounds like a solution that could help our results, the politics of Wall Street and Washington make the chances of this happening distant and remote. Besides, even if fees were reduced, the effect they would have on the amount of income we can expect to receive at retirement is minimal at best.

CONCLUSION

So, is all hope lost?

Not quite.

Congress and many economic support groups are well aware of these issues and have recently proposed some interesting solutions such as:

• Giving tax incentives to people who convert their plan into pension type of income at retirement via an annuity.
• Limiting access to accounts before retirement.
• Developing a system that can protect against loss of principal.

While these are ideas being proposed for the future, some are actually available today but are not widely known or promoted because they do not support the traditional system currently in place. Ironically, as a result of the repeal of the Glass-Steagall Act (which I’ll detail more in the next post), the competition is now coming from the insurance industry which is the very organization that handles the payouts from lotteries, pensions, structured settlements and other forms of distribution that require at least some form of income guarantees.

By planning ahead, we can use the distribution capabilities of the insurance industry to:

• Eliminate or minimize tax.
• Protect the account from market loss.
• Eliminate or reduce fees.

In my final post of this three-part series, I will cover the proper techniques for doing this and show how employing them can increase the efficiency of retirement income dollars by two to four times the amount when compared to the traditional retirement plans I’ve been discussing.

Stay tuned, and until then, feel free to email me with any questions you have.

Proceed to Part III here.

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

Here’s a trivia question: what does Jay Leno, prescription drugs, the iPhone and the 401k all have in common? Answer: they’ve all appeared on recent covers of Time Magazine. 

Although I can sing lots of praise for my iPhone, I can’t say I share similar enthusiasm about 401ks and other retirement accounts like it.

Surprising to many, the 401k was never designed to be the vehicle meant to carry people through their retirements. Quite the contrary, the 401k was originally only meant to be nothing but a cash supplement to pensions, not a replacement of them.

Back in the seemingly ancient days of pensions, many workers retired with their pensions well intact but a problem existed in that they often had limited cash reserves to supplement their monthly checks. To solve this problem, back in the late 70s Congress created what was supposed to be nothing but a minor provision in the tax code that allowed employees to take a percentage of their income, contribute it into a 401k and defer the tax so that when they retired, they’d have this “side fund” of savings to draw from.

The theory of giving workers a retirement side fund sounded great until corporate America found a self serving opportunity nested within it. After all, designing and managing pensions required additional staff, they were costly, risky and carried lots of responsibility. As such, many corporations found a way to cut costs and risk by shifting the responsibility of lifelong retirement income to their workers through the framework of the 401k (and other types of IRS qualified plans such as 403bs, TSAs, etc.).

I don’t know about you but if I wasn’t in the profession I’m in, I highly doubt I’d have much time to understand how to essentially be my own pension manager. To place this responsibility into the hands of the public who understandably has limited time and resources to be their own pension managers is just simply unfair and negligent. Furthermore, as we’ll soon find out, even if someone does successfully manage their own 401k to perfection, the chances of success are minimal at best given these plans are now being asked to do a job they were never intended on doing in the first place.

Let’s take a closer look.

1. INADEQUATE INCOME

Let’s take a hypothetical 40 year old named “Dave” who earns $80,000 per year and who is doing a heroic job of contributing the maximum amount allowed into his 401k. Contributing $16,500 per year (inclusive of a match) and miraculously achieving a steady 7% return each year less fees (soon to be discussed), at retirement age 65, Dave should end up with around $780,000 in his 401k.

Once retired, an important question then arises: how much income can he expect to receive from his account without outliving it?

The answer can be found in something called the “Withdrawal Rate,” a general rule of thumb that market historians and financial planning professionals generally agree to. The answer as to how much income one could safely generate from their account without outliving it is approximately 4% of its value. Any more than that percentage, then the chances for success are significantly decreased. True, an account might very well earn higher returns, but one needs to maintain a cash cushion for the bad years as well as the good, hence the lower-than-market-average Withdrawal Rate.

With the Withdrawal Rate in mind, the income Dave can expect to receive comes out to approximately $33,000 per year, which comes in at far less than a typical pension would have likely produced at around $58,000 per year (70% of his current income of $80,000; less if the pension is also established to cover a spouse).

If you’re interested in some quick rules of thumb that can help you determine the end result of your efforts, just follow this simple guideline:

Assuming a 7% growth rate less fees of 1.5%, simply take the amount being contributed into the retirement plan, then follow the math:

* If retirement is 15 years into the future, the gross amount of income you can expect to receive is 1x the amount being contributed. As an example, if $10,000 is being contributed, based on the 4% Withdrawal Rate and other assumptions just mentioned, you can expect to receive a before-tax income of $10,000 in your first year of retirement.

* If retirement is 20 years into the future: income will be 1.5x the contribution amount.
* 25 years in the future: 2x the contribution amount.
* 30 years: 3x the contribution amount.
(If there is a company match, simply increase the results by the match percentage).

Although not perfect and exact, the results will at least give you a general idea as to the results your efforts can generally be expected to produce. Of course, all this should be considered hypothetical and for example only.

Doesn’t sound too good? … It doesn’t end there. There’s something else that obviously needs to be taken into account:

2. TAXATION

The above income is all before-tax. Given money withdrawn from these plans and others like it are usually fully taxed as ordinary income, let’s assume when Dave retires he is in a modest 30% bracket. With this factored in, the net income for Dave would be somewhere around a mere $20,000, which basically equates to purchasing power of around $10,000 when adjusted for 3% inflation.

What chances does he have to survive on this level of income? The answer is most likely, “not much,” and hence, the conclusive reason why even in his near perfect situation of maxing out his contributions and achieving steady market returns without loss, using a supplemental plan such as a 401k to replace a pension can’t be expected to yield much success.

3. MARKET RISK

In a recent segment addressing the problems with 401ks, 60 Minutes summarized the risk issue quite well when asking, “What kind of retirement account allows people to lose 50% of their money the moment they are due to retire?”

4. COSTS

Different sources report varying costs but if I had to filter through all my research, I feel comfort in estimating total annual costs in the typical 401k, 403b, TSA, etc. coming in at around 1.5% – 2% per year. In many cases I’ve seen much higher. Just check out this astonishing Bloomberg report. To some, 2% might not sound like much, but if you earn an average gross return of 7% each year, 2% of those earnings equates to giving up nearly 30% of your gains. Ouch.

5. PERFORMANCE

Most retirement accounts such as 401ks, 403bs and others are comprised of a menu of professionally managed mutual funds. While I am not here to say negative things about funds, the fact of the matter is that the majority of them fail to outperform the static, low cost and unmanaged indexes they are benchmarking their returns to.

SOLUTIONS?

Some say pointing out the problems is easy, but what about the solutions? I have a couple of ideas to share, some of which are basic and others I know are creative and things you may have not heard before.

Stay tuned. I’ll detail them in my next post soon to come….

Proceed to Part II here.

The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans

If you’ve lost your job, or are changing jobs,you may be wondering what to do with your 401(k) plan account. It’s important to understand your options.

What will I be entitled to?

If you leave your job (voluntarily or involuntarily), you’ll be entitled to a distribution of your vested balance. Your vested balance always includes your own contributions (pretax, after-tax, and Roth), and any investment earnings on those amounts. It also includes employer contributions and earnings that have satisfied your plan’s vesting schedule. In general, you must be 100% vested in employer contributions after 3 years of service (“cliff vesting”), or you must gradually vest 20% per year until you’re fully vested after 6 years (“graded vesting”). Some plans have 100% immediate vesting. You’ll also be 100% vested if you’ve reached your plan’s normal retirement age.

Special vesting rules apply to certain plans, so make sure you understand how your particular plan’s vesting schedule works. This is important, because you’ll forfeit any employer contributions that haven’t vested by the time you leave your job. If you’re on the cusp of vesting, it may make sense to wait a bit before leaving, if you have that option.

Don’t spend it, roll it!

While this pool of dollars may look attractive, don’t spend it unless you absolutely need to. If you take a full distribution you’ll be taxed, at ordinary income tax rates, on the entire value of your account except for any after-tax or Roth 401(k) contributions you’ve made. And, if you’re not yet age 55, an additional 10% penalty may also apply to the taxable portion of your payout. (Because of the 5-year holding period requirement, there won’t be any taxfree qualified distributions from Roth 401(k) accounts until 2011 at the earliest. And special rules may apply if you receive a lump-sum distribution and you were born before 1936, or if the lump sum includes employer stock.)

If your vested balance is more than $5,000, you can leave your money in your employer’s plan until you reach normal retirement age. In many cases, however, your best bet will be to roll the funds over to an IRA. Your investment alternatives will be almost limitless, and you’ll have better control over when and how to take distributions from your account.

Your employer must allow you to make a direct rollover to an IRA. As the name suggests, in a direct rollover the money passes directly from your 401(k) plan account to your IRA. This is preferable to a “60-day rollover”– where you get the funds and then roll them over to an IRA yourself–because your employer has to withhold 20% of the taxable portion of a 60-day rollover. You can still roll over the entire amount of your distribution, but you’ll need to come up with the 20% that’s been withheld from other funds until you recapture that amount when you file your income tax return.

If you really do need to use some of the money, and you have nontaxable after-tax or Roth contributions in your account, keep in mind that you may be able to roll over the taxable portion of your distribution to an IRA, and take a distribution of just the nontaxable portion of your account.

What if I have an outstanding plan loan?

In general, if you have an outstanding plan loan, you’ll need to pay it back, or the outstanding balance will be taxed as if it had been distributed to you in cash. If you can’t pay the loan back before you leave, you’ll still have 60 days to roll over the amount that’s been treated as a distribution to your IRA. Of course, you’ll need to come up with the dollars from other sources.

Most people do a fantastic job of protecting themselves, their family, car, house, etc.. Heck, I even protect my new iPad by sleeping with it under my pillow.

For most people, their most important retirement asset will be their 401k so knowing a bit about to protect it can be useful.

The extent to which your 401(k) plan account is protected from the claims of your creditors depends on two things: (1) whether your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), and (2) the type of claim (in bankruptcy or outside of bankruptcy).

Most 401(k) plans are covered by ERISA. ERISA contains an “anti-assignment” rule that provides broad protection from creditors’ claims. This anti-assignment rule applies whether you’ve declared bankruptcy or not– no bankruptcy or judgment creditor can reach your 401(k) plan account, if the plan is governed by ERISA. (There are several important exceptions to ERISA’s anti-assignment rule. For example, the IRS may be able to levy against your 401(k) plan account for failure to pay your taxes. And a court can issue a qualified domestic relations order (QDRO) that will require the plan to pay all or part of your plan benefit to your former spouse.)

But again, this broad protection applies only if your 401(k) plan is governed by ERISA. Some plans are not. For example, a plan that covers only a business owner, or the owner and his or her spouse (i.e., an “individual 401(k)” plan), isn’t covered by ERISA. Plans sponsored by governmental entities and certain churches aren’t governed by ERISA either.

If you participate in one of these plans, you won’t be able to rely on ERISA at all for protection from your creditors. What happens then? Your 401(k) plan account will still be fully protected from your creditors if you declare bankruptcy, as a matter of federal law. But whether you’ll be protected from creditor claims outside of bankruptcy will depend on the laws of your particular state. While most states provide at least some protection for retirement accounts, some do not. You’ll need to consult a qualified attorney to determine how the laws of your state apply to your particular situation.

Traditional and Roth IRAs generally aren’t subject to ERISA (we’ll discuss SEPs and SIMPLE IRAs later). Therefore, they don’t qualify for the broad protection from creditors that ERISA typically provides. However, even though ERISA doesn’t apply, federal law still provides protection for up to $1,095,000 (in 2009) of your aggregate traditional and Roth IRA assets if you declare bankruptcy.

If you’ve rolled any funds over from a 401(k) or 403(b) plan (or another qualified plan) to your IRA, then those assets, and any earnings on them, aren’t subject to the $1,095,000 cap, and are fully protected. (You may want to consider setting up a separate IRA to hold rollover funds so that you can more easily identify the amount eligible for full protection if you declare bankruptcy.)

But, with IRAs, federal law governs only bankruptcy claims. Whether you’ll have protection from your creditors outside of bankruptcy will depend on the laws of your particular state.

Different rules apply to SEP IRA and SIMPLE IRA plans. SEP and SIMPLE IRAs are fully protected from your bankruptcy creditors under federal law–the $1,095,000 limit doesn’t apply. But whether or not your SEP/SIMPLE IRA has protection from your creditors outside of bankruptcy may depend on whether your plan is governed by ERISA (because it covers one or more common law employees).

If your SEP/SIMPLE IRA plan isn’t subject to ERISA, whether you’ll have protection from your creditors outside of bankruptcy will likely depend on the laws of your particular state.

But if your SEP/SIMPLE IRA is governed by ERISA, whether you’ll have protection under state law from creditors outside of bankruptcy is not clear. These plans are not covered by the part of ERISA that protects assets from creditors generally. But they are subject to the part of ERISA that preempts state laws. So state laws that may have provided protection for your SEP or SIMPLE IRA account from nonbankruptcy creditors may not be available.

These rules are obviously quite complicated. Be sure to consult a qualified attorney if creditor protection is important to you.

401k? IRA?

iPad? iPhone? The family cat?

Regardless of what you are trying to protect, a little information can indeed go a long way and I hope this short column was well worth your while.

No matter how good a company you work for, you should think carefully about how much you should have invested in it. Yes, there are companies whose employees have become wealthy from company stock that was part of their compensation. But there also are stories about employees of companies such as Enron, Bear Stearns, and Lehman Bros.–people who believed in their employers but learned the hard way that allowing one company– especially a current employer–to dominate their investment or retirement portfolio can have devastating consequences.

According to the most recent Employee Benefit Research Institute statistics (Issue Brief No. 308, August 2007), company stock represents According to the most recent Employee Benefit Research Institute statistics (Issue Brief No. 308, August 2007), company stock represents an average of 11% of 401(k) plan participants’ assets (though that percentage is less than in previous years). However, few mutual fund managers would allow a single stock–any stock–to represent that much of a fund’s portfolio. And a corporate pension plan is actually prohibited from investing more than 10% of its holdings in the company’s own stock.

Ironically, the better your company’s stock has performed, the greater the chance that it may have grown to dominate your portfolio. However, even if your company is a good one, working at a company means you’ve invested your “human capital”–your earning ability–in that firm. If you also have a large portion of your investment capital there, your financial well-being is even more dependent on a single company. If a company’s stock is suffering, it might react by cutting jobs companywide. If yours were one of them, both your human and investment capital would be hit.

And don’t forget to consider whether an equity mutual fund you hold also may have invested in your company’s stock. You can find out a fund’s holdings by checking its annual and semiannual reports. You can use the information to estimate your total exposure to your employer’s stock.

If stock options are part of your compensation package, a significant market downturn can mean special financial pain.

In many cases, people who receive options to buy their company’s stock find that during a downturn, the stock’s market price is lower than the option’s exercise price. Since few would choose to exercise an option that requires paying more than the market price, the option is said to be “underwater”–a situation that was widespread last year. If your options are underwater, it’s worth checking to see if your company has considered asking its shareholders to approve repricing the options, or exchanging them for a smaller number of options with a lower exercise price. Some companies are taking such steps to try to retain valued employees.

If you exercised options to purchase your company’s stock in 2008, you may face a more complex problem. The type of option and when you exercised it can raise a number of issues at tax time. If you own nonqualified stock options, you’ll generally owe ordinary income tax on the difference between the exercise price and the stock’s market value as of the date you exercised it. That amount is considered compensation and, if you’re an employee, should be listed on your W-2 form.

If you exercised incentive stock options (ISOs), tax is ordinarily deferred until you sell the stock that you acquired. However, unless you sold the stock in the same year that you acquired it, you have to factor in the alternative minimum tax (AMT). For AMT purposes, when you exercise an ISO, income is generally recognized to the extent that the fair market value of the shares when acquired exceeds the option’s exercise price. This means that a significant ISO exercise in one year can trigger AMT liability, even though no income is actually received. This application of AMT could be a real problem if you exercised the options in early 2008 and later saw the value of the stock you received dramatically decline in value. If you are subject to AMT as the result of an ISO exercise, you’ll be entitled to a resulting AMT credit that can be used in future years.

The Emergency Economic Stabilization Act of 2008 included some relief for taxpayers who exercised ISOs prior to 2008, and makes it easier to claim unused AMT credit. However, it will be of little help if you exercised ISOs in 2008. For more information, talk to a tax professional.

Roth conversions

Individuals who would like to contribute or convert to a Roth IRA in
2009 but don’t qualify because of income limitations might benefit from making nondeductible contributions to a traditional IRA today, and converting the funds to a Roth IRA in 2010, when the income limits no longer apply. Additionally, for Roth conversions in 2010 only, any resulting taxable income will be deferred until 2011 and 2012 (with 50% taxed in each year).

No doubt, 2008 was one of the worst years in the history of the stock market, and one of the worst for retirement savings. Here are four things you can do now to help make the best of a bad situation.

1.Review your retirement plan Review your overall retirement plan with your financial professional. What, if any, adjustments can you make to help you reach your retirement goals? If you were planning to retire in a certain year, determine if that’s still realistic, and calculate how much longer your assets might last if you work a few years longer. Can you reach your goals by using a smaller withdrawal rate assumption, or by increasing your IRA or 401(k) savings? Does your asset allocation still make sense? And if you don’t have a plan for your retirement, now is a good time to think about establishing one.

2.Convert your traditional IRA, or transfer 401(k) plan securities, to a Roth IRA

Due to declining values, the tax cost of converting to a Roth IRA has dropped dramatically for many investors. Consider whether converting to a Roth IRA makes good financial sense for you. The taxable portion of your traditional IRA will be subject to ordinary income tax in the year of conversion, but qualified distributions from your Roth IRA will be entirely free from federal taxes.
For 2009, you’re able to convert only if your modified adjusted gross income is $100,000 or less (this dollar limit applies whether your tax filing status is single or married filing jointly). If you’re married filing separately, you can’t convert at all in 2009. But if these rules preclude you from converting, there’s always next year–literally. These limitations are repealed in 2010, so anyone will be able to convert a traditional IRA to a Roth, regardless of income level or marital status.
Similarly, if you’ve decided a Roth IRA makes sense for you, and you’re entitled to a distribution from your 401(k) plan, keep in mind that you can roll over (that is, essentially convert) your non-Roth assets to a Roth IRA (hardship withdrawals, certain periodic payments, and required minimum distributions (RMDs) can’t be rolled over). This may be especially attractive if you’re entitled to an in-kind distribution of employer stock whose values are seriously depressed–you’ll pay tax on this reduced value and any additional appreciation may be
tax free.(The same income and marital status limitations that apply to traditional IRA conversions also apply to rollovers from 401(k) plans to Roth IRAs in 2009.)

3.Undo a 2008 conversion in 2009

What if you already converted your traditional IRA to a Roth in 2008,and your IRA balance has taken a significant hit since then? The tax cost of converting was probably much greater than if you had waited until 2009 to convert. Well, don’t fret–you can undo a 2008 conversion up until the due date for filing your 2008 tax return, including extensions. Technically called a “recharacterization,” this procedure allows you to treat the conversion as if it never occurred.

To undo your 2008 conversion, you need to carefully follow these steps:

•Inform your IRA providers (the one holding the Roth IRA and the one providing the traditional IRA, if different) that you intend to recharacterize your Roth IRA to a traditional IRA. You must provide this notice on or before the date the assets are transferred back to the traditional IRA

Make sure the transfer is completed by the due date for filing your federal income tax return for 2008, including extensions. For most taxpayers, that can be as late as October 15, 2009. (If you’ve already filed a timely 2008 tax return, you can still recharacterize by making the transfer and filing an amended return by October 15, 2009.Be sure to write:”Filed pursuant to Section 301.9100-2″on your Form 1040-X.)

•Report the recharacterization to the IRS (see Form 8606 for more information).

You can even reconvert your traditional IRA back to a Roth in 2009 (if you meet the eligibility requirements) beginning on the 31st day following the recharacterization.

4.Continue to contribute

Despite the recent downturn, for many people IRAs and employer retirement plans remain important vehicles for retirement savings. Make sure you’re taking full advantage of any company matching contributions you’re entitled to. And if you’re age 50 or older, keep in mind that you may also be able to make catch-up contributions (up to $1,000 for IRAs and $5,500 for 401(k) plans in 2009).