Thomas from Ticonderoga, NY:
I am a 54 year old pilot still flying for American Airlines. One consequence of our bankruptcy is that our B-Fund (Defined Contribution Pension) is being frozen as of November 1. Subsequently we will have three options, as the plan will no longer be maintained. 1) Take a lump sum distribution; 2) Roll it into the current 401k plan; or 3) Roll it into an IRA. What should I do?
We have received numerous calls with this very same question. While there is no single “right” answer for everyone, we’ll highlight the pros and cons of each of your three choices, which should provide some guidance.
Lump Sum Distribution – It is unlikely that this is your best option. If you took a distribution, you would incur tax obligations on the entire amount in the year in which you took the distribution. Since you are still working, a distribution would likely put you in the highest federal tax bracket (or close to it). Because you are under 59 ½, you would likely have to pay an additional 10% penalty to the IRS for early withdrawal. Even if you were over 59 ½, we always recommend keeping as much of your funds in a tax deferred vehicle (such as a pension, IRA, or 401k) as possible. So, unless you were in dire financial circumstances where you happen to need a large sum of cash immediately, which you wouldn’t be able to repay in the near future (since you could borrow against your 401k), a distribution is really not your best option.
Roll into the 401k – There are a few advantages of a 401k plan over the IRA alternative. Here are three to highlight.
1) Delay RMDs until after retirement – If you plan on working until you are over 70 ½ (even if you have to stop flying by 65, you could potentially stay on in an instructional role, or some other capacity), a 401k doesn’t require that you take Required Minimum Distributions (RMD), while you are still working (unless you own more than 5% of the employer’s stock). This allows you to keep the maximum amount in a tax deferred status. Keep in mind that you would still be obligated to take RMD on OTHER retirement accounts, such as IRAs, even while you are still working.
2) Borrow against your 401k – If you need a material sum of cash now, but WILL be able to pay it back in the foreseeable future, you can borrow against your 401k (which you cannot do against an IRA). We generally recommend borrowing against some other collateral that provides cheap funding, such as your home or car. But, if that is not an option, borrowing against your 401k may be a reasonable choice.
3)Legal protection – As we understand it (keep in mind we are not attorneys and are not providing any legal advice), ERISA laws protect 401k plans (along with Pensions and 403b plans) from creditors. Most states offer limited or no protection for IRAs. So, if you have creditors or may find yourself amidst a law-suit, you should consult your attorney for legal advice regarding the protection of your retirement assets. Rolling into the 401k may be a better choice than an IRA in these circumstances.
Roll into an IRA – For most individuals, this is the best choice, with of course the exceptions listed above. The main benefits of an IRA over a 401k are as follows.
1) Much broader investment selection– Your 401k plan has 30 funds from which to choose. An IRA Rollover gives you much greater flexibility in investment selection, allowing investment in well more than 10,000 funds and individual securities. Your current 401k plan may not have funds representing all of the exposures that you would like to include.
2) Lower cost fund alternatives – There are inherent costs of running a 401k plan, which include Administration, Recordkeeping, Custody, and Advisory services (fund selection, monitoring, etc.). In many plans, some or all of these costs are paid by the mutual funds, which increase their expense ratios, which of course are ultimately paid by you. Even if you like the positions you currently have in your 401k, you will likely find cheaper alternatives that can be utilized in an IRA.
3) Restrictions and penalties – Your 401k plan has restrictions on when you can repurchase a position that you have sold within 90 days of your prior purchase. In addition, you will have to pay an early redemption fee (as high as 2%!) on 7 of the funds, if you sell within a set time frame (from 30 to 180 days). Investors generally appreciate that they can choose investments without these restrictions in their IRA. Note that some investments you could choose to put in your IRA may have restrictions as well (or penalties for early redemption), but there are a plethora of choices with no restrictions or penalties.
4) Hiring a money manager – Should you decide you wish to hire a money manager (such as Friedenthal Financial), you can do so with an IRA. Your 401k plan does not allow you to hire your own advisor or manager.
Keep in mind that once you are over 59 ½, or if you are no longer employed by American (retired or otherwise), you are free to roll out of your 401k into an IRA rollover.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
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If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.