Drill Down: Should You Move Your Old 401k to Your New Employer?

Moving your old 401k to your new employer’s 401k plan is a reasonable thing to do, but not my first choice. Keep in mind, however, that not all employers allow plan-to-plan rollovers. The old employer has no say in the matter; if you want to move the 401k, you can. But the new employer may or may not allow rollovers. So if you’re inclined this way, check out with your new company what its rules are.

The advantage of the rollover to another 401k is that all of your money is together in one place. It’s not that the money gets lonely if it is separated from its cousins. The benefit of the rollover is that you only have one account to think about. You can make all of your asset allocation decisions inside one account. When you retire, you will be able to draw money from a single plan rather than from multiple plans. This constitutes a small convenience. If you have a busy, hectic life, I understand your desire to keep things simple.

The downside of the rollover into a new 401k plan begins with its cost. If you skipped the section on keeping your 401k in the old plan, read it now. It explains that the cost of the mutual funds in your 401k plan is likely to be higher than the best deals you can find in mutual funds for an IRA. For that reason, I like rolling over into IRAs better than anything else. But it’s not hugely wrong to roll over into a new 401k plan, just not my preferred choice.

Before rolling your old 401k plan into a new one, check out two things about the new plan. First, make certain that it has enough choices for you to allocate your assets the way you want to. If not, I can guarantee that a good IRA offers all the choices you could possibly need—and more.

Second, check the fees on the mutual funds in your new 401k. If they are running more than one percent of the fund’s assets, you can do better in an IRA. (Don’t worry if the foreign funds cost more than one percent; they are more expensive to operate.) If your funds are costing more than 1.50 percent, then definitely do not roll over into a new 401k. Instead, go into an IRA. Reread the discussion of fees in the investment chapter.

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Drill Down: Company Stock in Your 401k

I pledged to keep this book simple, but I’m afraid I’m going to fail in this section. If, however, you are willing to work through this section, you may be able to save a good deal of taxes (enough even to make this section worth reading). You will find this material relevant if you have company stock in your 401k that has risen in value substantially.

Example: Jane’s company matches her 401k contribution by putting company stock into her account. The value of the stock, as of the day that each company contribution was made, totals $20,000. But the stock price has been going up, resulting in a total market value for the stock of $100,000.

Jane has an option not listed above, but she has to be careful to do it right:

1. Set up a stock brokerage account and have the company stock transferred to that account.
2. Have the rest of the money in the 401k rolled over into an IRA.

Both of these actions have to be taken in the same tax year. Note that Jane has to take out the actual company stock; she cannot sell the stock inside the 401k and then take out the money she receives from selling the stock.

Here’s what happens tax-wise to Jane. She is taxed this year on the cost basis of the stock. That’s the $20,000 that the stock was worth on the days she received her various matching contributions. She has to pay tax on that amount in the year that she moves her stock into her brokerage account. If she’s not yet 59½, she’ll also have to pay the ten percent penalty tax.

Now that sounds bad, paying a tax early, but the rest of the story is very nice. The profits on the stock will be taxed at the long-term capital gains tax rate, at the time that she eventually sells the stock.

Remember the normal taxation of 401k money: it’s all at regular tax rates.

As I am writing this, capital gains tax rates are much lower than regular tax rates (though who knows what those crazy guys in Congress will do next year). For instance, let’s assume that your income is in the range of $61,300 to $123,700. Your regular tax rate is 25 percent on any additional income. But long-term capital gains are only taxed at 15 percent.

Let’s do Jane’s arithmetic. The regular tax liability on the entire $100,000 (ignoring that the income would probably push her into a higher tax bracket) is $25,000.

By taking the stock out, she has a tax of 25 percent of $20,000 (which is $5,000) plus 15 percent of $80,000 (which is $12,000), for a total tax of $17,000. That’s a lot less than $25,000 if she has to pay regular income tax on top. Her state income tax, if any, would throw another complication into the Jane’s arithmetic.

However, this calculation is a little too simplistic. First, if all the stock goes into her IRA, she does not have to pay any tax at all until the money comes out. If she has other resources, she can delay taking any money at all out until she reaches 70½ years old, and even then she can withdraw money at the minimum distribution. (That’s explained in the following section.) With the stock transfer choice, though, she has to pay tax on the cost basis of the stock right away, even if she does not sell the stock for a while.

There are two other benefits, though, to the stock transfer. Not only does Jane get capital gains tax rates on the stock’s gains, but she is in complete control of when she sells the stock. As we’ll learn in the following section, the IRS has minimum distribution requirements for money in your 401k or an IRA. As there is no minimum distribution requirement for the company stock you withdraw, you can hold it so long as it suits you.

If you die while holding the stock, your heirs will inherit it with no further tax due on the capital gains. That’s called “stepped up basis.” It doesn’t make any sense, but it’s the law. Although it doesn’t help you out, your children will be better off after your funeral.

This all sounds fairly complicated, especially as the perfect answer depends on a lot of assumptions like future tax rates, rate of return on investments in the future, how long before you will sell the stock, and so forth. I’ve done the hard part for you though, running many simulations of different circumstances. Surprisingly, they all came to pretty much the same conclusion:

• If the cost basis of your company stock is less than 40 percent of the stock’s current value, then you’ll probably be better off withdrawing the stock separately.
• If you are in the highest tax bracket (33 or 35 percent), you’ll probably be better off withdrawing stock if your cost basis is 60 percent of total value or less.
• If you are going to have more than enough money for your retirement, and you want to leave as much as possible to your heirs, then you’ll probably be better off withdrawing stock regardless of the tax basis.

The other issues only make a small difference. Also, if you are near the breakeven point (40 percent for most people, or 60 percent for the highest income brackets), then don’t worry. There is hardly any difference between the two possibilities if you are in the neighborhood of the breakeven point, so don’t bother sharpening your pencil. Unless, of course, you are one of those people who insists on squeezing every last penny out of your investments.

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Drill Down: Minimum Required Distributions

Let’s first talk about the minimum amount of money you must withdraw. The government calls it a “distribution,” and I’ll use that word to get you used to it. The government requires that you take money out so that your tax advantage does not last forever. They want to make sure that you eventually pay some taxes.

Here are the rules about when you have to start taking distributions:

• If you have retired, you must begin taking distributions by April 1st of the year after you reach age 70½.
• If you are still working at age 70½, you may not have to take distributions until April 1st after you retire, but check with your employer for exceptions.

The minimum amount that you have to take out is determined by the Internal Revenue Service. The idea is that you divide your 401k balance by the number of years you have left to live. Even the IRS does not know exactly how many years you have left, so they use the average for people your age.

There are three different ways to calculate the number of years, but the most common table, the Uniform Lifetime Table, is reproduced below. It is applicable to most people, but if you have a spouse more than 10 years younger than you, you can use a different table that provides a longer distribution period and thereby lowers the minimum required distribution. That table was created because your spouse may live a good bit longer than you, and you may want the 401k to last through his or her lifetime. Finally, beneficiaries have a different table. If you die and leave your 401k to your wife, she as the beneficiary will have to take money out more rapidly.

Here’s the Uniform Life Table, the one most commonly used, current at the time of this writing:

Because the IRS may revise the life table from year to year, you should get the latest table directly from the IRS, or consult an accountant or financial planner to make sure you are using up-to-date information. You should be able to find the latest IRS table by searching for the following keywords: IRS uniform lifetime table.

The minimum distribution is recalculated every year. So let’s say that you are 71. You must take one 26.5th of your account balance out, which is 3.77 percent. The calculated result will change when you are 72 because your account balance may be larger (if your investments grew by more than 3.77 percent over the year), and because at age 72 you have to take out one 25.6th, or 3.91 percent.

If you take more than the minimum distribution in one year, you will still be required to withdraw the minimum in future years. You are NOT allowed to withdraw less than what is required because you exceeded the minimum in a previous year.

Installment withdrawals are allowed. That means you can figure your minimum payment, then divide by 12, and take out that amount every month. It is as convenient as a paycheck, and you never have to go to work.

If you have more than one retirement account (not counting IRAs), you have to figure out the required minimum distribution for each account, withdrawing from each account what is required. However, the rules for Individual Retirement Accounts are a little different. You still compute the minimum required distribution for each account, but you get to choose which IRA to take the money out of. You can pick just one, or take distributions from all of your accounts. For this reason, rolling your 401k into your IRA simplifies your life.

Let me give you one last word on minimum distributions. What happens if you fail to take the minimum distribution? The IRS does not come to your home and shove the money down your throat. What they actually do is worse: They charge a 50 percent tax on the money you should have taken out but didn’t. So be careful about your paperwork, and make sure you withdraw enough money each year.

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Drill Down: How Much Should You Take out of Your 401k?

What does this mean in real life? Do you want to withdraw the minimum or something more than the minimum?

Let’s look at an idealized picture of your retirement account. You start saving when you are young, build up your account balance throughout your working years, and finally pull money out for your retirement. If you plan everything correctly, there’s just enough money left when you die to cover your funeral bills. Your 401k balance will look something like this.

By the way, if that looks like a lot of money, that’s because it is. But it’s a reasonable assumption. The worker behind this account—let’s call him Joe—is an average person, who made an average salary of $38,000 a year. He earned less when he was younger, and more when he was older. At age 65, Joe was making $65,000 in earnings. His first year distribution from his 401k was more than the minimum: it was just over $50,000. Social Security would probably provide around $21,000 to $24,000 a year, so Joe is better off in retirement than when he was working.

If that sounds too good to be true, that’s because it is. Joe could live longer than his official life expectancy. He really should budget as if he may live to be over 100. In fact, I prefer to plan to live to be 105 years old. If Joe follows my advice, he cannot take $50,000 a year out of his 401k; he can only withdraw $26,000 during his first year.

There is a bit of good news, though. My withdrawal plan increases the amount for inflation, so that Joe won’t have a problem with lack of purchasing power as the years go by.

How well will Joe live in retirement? Some of his Social Security earnings will be taxed. (The details are complicated by the amount of Social Security benefits that are taxed ranges from zero to 85 percent, depending on your circumstances.) After taxes, Joe will have about 83 percent of his former salary to live on. Many retirement planning experts believe that’s enough because most people have lower expenses when retired. Also, the hit to Joe’s standard of living isn’t as great because Joe wasn’t living on all of his salary; he was investing nearly $4,000 a year into his 401k.

Wait, though. This little exercise assumed that Joe’s investment returns were about average. For the time period when Joe was working, I assumed that his total return averaged eight percent a year, a reasonably conservative estimate. I further assumed that he shifted his asset allocation more into bonds and money market funds, earning only five percent per year. I think that’s fairly conservative, but it may not be conservative enough. It’s possible that while Joe still had a good portion of his investments in stocks, the market tanked. It’s possible that the bond market went down because of rising inflation. We can’t be sure what his investment returns will be.

Monte Carlo Solution

Researchers have pondered this problem, and found an answer based on “Monte Carlo simulations.” Monte Carlo is that city famous for its casinos. In a Monte Carlo simulation, a computer pulls numbers out that reflect likely returns on investments. The computer is taught the average return, and how often returns are above and below average, and by how much. The resulting answer is often called a “Probability of Ruin, ” the probability that you will outlive your money.

Withdrawals are assumed to increase with inflation, and investments are assumed to be balanced between stocks and bonds. Simulations show that if you pull five percent of your money out of your 401k starting at age 65, you’ll have enough to live on about 75 to 80 percent of the time. The rest of the cases you’d be surviving strictly on social security, scouring the stores for discount dog food to enjoy as your daily meal.

To get that probability of ruin down to just one or two percent, you’ll need to withdraw only three or four percent of your 401k balance.

Bill’s Withdrawal Recommendation: Plan on withdrawing only three percent of all your retirement savings. Once you start, bump up the amount you take out every year for inflation.

What if you only withdrew the required minimum? In this case, you could be confident that your money will last your entire lifetime, even if you reach your 105th birthday. This method, however, has problems as well. Withdrawing the minimum isn’t a good guide because your account balance will be declining when you are in your 90’s. As a result, your required minimum distribution will also be declining. You’d like your distribution to go UP with inflation, not down. As an alternative, you might try taking the minimum until that stops going up by at least inflation; when you reach that point, increase your withdrawal every year by the rate of inflation. With reasonable investment returns, that will take you past 100, but not to 105 years old.

Bill Says: To have an adequate cushion to live a long time or have bad luck with your investments, you need some investments beyond your 401k.

What if you planned your withdrawal rate based upon how much you need? The preceding approach started with how much money you have in your 401k plan and telling you how much you can take out. Coming at the problem the other way would be to figure out how much you need. You might estimate your expenses after retirement, which many financial planners assume is about 70 percent of what you earned when you were working. Joe, who retired at a salary of $65,000 a year, needs $45,500 a year. Social Security will give him about half of that, so he only needs $20,000 to $25,000 a year.

My problem with the needs approach is what happens if your need does not match your investments. Needing a certain amount a year, and then running out of money when you are still alive, is not a very pleasant thought. The bottom line is you cannot afford to take out much more than three percent of your retirement money when you are just starting your retirement.

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Drill Down: 401k Withdrawals and Other Assets

All this information about how much to withdraw is good, but you are likely facing another challenge. It’s quite possible that you have accumulated assets other you’re your 401k throughout your lifetime. You might ask, “From which account should I withdraw funds first?” This could seem especially complicated if you have numerous assets like a CD, a 401k, an IRA, and stocks, but don’t worry. The reasoning is straightforward and we’ll take it one step at a time and go through some examples to make it clear.

Let’s start with a simple example. Assume you have a 401k plan and a CD (or a savings account), and now you’re looking to fund your retirement. From which one should you make a withdrawal first? It should definitely be from your CD (providing that it’s not within an IRA), and I’ll explain why.

As we’ve mentioned before, what makes a 401k plan such a great investment vehicle is that it permits your money to grow, tax deferred. By holding off on making withdrawals from your 401k plan, you are making your money work for you. All that you have contributed over the years will continue to grow as quickly as it can, without taxes undermining your efforts, to give you even more to carry you through your latter retirement years. That’s always a good thing. Compound interest and tax deferral are what make it possible, and that is a combination lacking with your CD.

In short, you should withdraw money from your CD or savings account before your 401k, or even before other assets like IRA’s, stocks, or mutual funds.

What if you have an IRA in addition to your 401k and CD? Or what if you have a complicated asset combination that includes a 401k, CD, Roth IRA, and bonds? What would be the ideal order to withdraw funds? This may seem complicated, but don’t worry, it isn’t. There is a general strategy for withdrawing your funds and it is outlined below.

General Withdrawal Strategy

First: Use your most liquid assets that are not tax-sheltered (i.e. you are taxed on all gains—no tax is deferred) and have the lowest rate of return. This can include savings, CD’s, and others.

Second: Begin tapping into your others assets that are earning a higher return, but the gains are still taxable. This can include mutual funds, stocks, bonds, etc. that are not part of a retirement plan.

You may need to do some rebalancing along the way. For example, a smart strategy for someone who has both a 401k and a regular, taxable investment account is to put stocks in the taxable account, and bonds in the non-taxable account. That makes sense because the stocks enjoy lower capital gains tax rates.

However, if you sell those stocks, you may not have the right balance of stocks and bonds. You can easily restore your desired balance by shifting assets within your 401k. Sell some bond funds and buy some stock funds.

Third: Once all your taxable accounts are used, now you can tap into your retirement plans. It is important to leave these until the end to take full advantage of that tax-deferred growth. Now let’s say you have a traditional IRA, Roth IRA, and a 401k plan. Which order? It really depends on what the tax situation looks like. If you are in a high income tax bracket early on in your retirement, and you expect to be in a lower one later, tap into your Roth IRA first. You’ll be able to pull out your funds without paying the high taxes (since you paid them already). If the situation is reversed and you’re in a lower tax bracket early on in your retirement but expect, for some reason, to be in a higher one later, use your traditional IRA or your 401k first. If you have a Roth 401k and a traditional 401k, just follow the same reasoning for the IRA.

That is all there is to it. The basic strategy is to let your funds grow as long and fast as possible (without unnecessary tax). With the information here, you are well on your way to making your retirement secure.

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