Ted's Table

Technical Terms Early withdrawal penalty Employee Retirement Income Security Act Plan document

TB: The ultimate responsibility falls on the employee, but the employer also plays an important role. The employer is required to ensure that the limit isn't exceeded but this can be difficult if an employee contributes to two plans in the same year. When the annual dollar limit is exceeded, it is up to the employee to inform the employer of the excess contribution and to request a refund of the excess plus applicable investment return. This notice must be filed with the employer by March 1 following the year the excess was contributed.

You may wonder why the employee has to inform the employer. It is increasingly common, due to shorter eligibility waiting periods, for an employee to be able to contribute to two plans during the same year as a result of a job change. The potential for exceeding the limit is increased whenever contributions are made to two employers during the same year, because the second employer has no way of knowing how much the employee contributed to the first plan.

The employee has the right to decide which plan should refund the excess amount. This is why the employee must inform one of the employers of the excess amount. The excess must be refunded by April 15th of the year following the year that it was contributed. The employee has a good reason to make sure the refund is made in a timely fashion — if the April 15th date is missed this amount must be left in the plan until it can be distributed as a benefit distribution payment. It will be taxed twice: once during the year it is contributed and again when it is distributed.

I have addressed which plan should make the refund in previous columns. Generally, I recommend that you ask your former employer to make the refund.

TB: You are right on target. Some participants want complete investment flexibility but many participants have great difficulty picking from just a few funds. Despite this apparent conflict, I believe the number of plans offering unlimited choice will continue to grow as employers respond to pressure from those vocal participants who will not be satisfied with anything less.

I am concerned about what happens to those quiet participants who are struggling to handle this responsibility. I am also concerned that many participants, looking at the extraordinary market returns achieved during the 1990s, have very unrealistic expectations about what this new freedom will get them.

Building an adequate retirement nest egg requires both saving and investment discipline over an entire working career in most instances. As you have pointed out, wanting to get there the fast, easy way tends to lead to emotional rather intelligent investing. Sometimes people get lucky and break this pattern but it isn't a very solid way to build a retirement strategy.

TB: Legally, after-tax contributions may be withdrawn any time for any reason as long as the plan document permits doing so. There isn't any reason for tying the withdrawal of after-tax contributions to hardship withdrawals. The primary reason for having after-tax contributions is to give participants easier access to these funds than is possible with pre-tax contributions. Frankly, I have never heard of a plan that limits the withdrawal of after-tax contributions to financial hardships. But, it is possible.

When after-tax contributions are withdrawn, it is also necessary to withdraw the applicable investment gains. The investment income that is withdrawn is fully taxable.

Your question regarding the applicable tax to withhold is an interesting one. Hardship withdrawals are subject to 10 percent tax withholding on the taxable portion. Other distributions are subject to 20 percent mandatory tax withholding. In my opinion, the 10 percent rate would apply if the withdrawal of these contributions were really subject to the hardship withdrawal rules according to the plan document. Of course, the employee must ultimately pay tax on the investment income that is withdrawn based upon his personal tax rate plus the 10 percent early withdrawal penalty tax.

Question: Does a 401(k) provide a higher level of protection than an IRA against civil lawsuit judgments and other types of asset-attachment actions? The major fund companies never seem to discuss this aspect of the two retirement savings options when they present reasons to roll a 401(k) account at a former employer into an IRA. Yet, as my husband and I build substantial retirement assets, I've become more aware of how litigious society has become. If the investment options within my former employer's 401(k) are good, as mine are, why roll over the money to an IRA?

TB: You do have a somewhat higher level of protection from legal claims when you leave the money in a 401(k). The money held in 401(k) plans is protected by the Employee Retirement Income Security Act. This is an advantage if you are worried about litigation. IRA assets, on the other hand, are covered by state laws. Not all states have laws protecting IRA money and those that do may not be uniform with other states.

There isn't any reason to rush to roll the money into an IRA if you are satisfied with the investments and if your employer is stable.

The fact that the situation can change rather quickly, however, is a factor to consider. Your employer can change the investments at any time either by moving the plan to a new service provider or if the business is sold.

I speak from experience. I left some retirement money with a former employer because I was comfortable with the investments. The company was sold about a year after I left. I didn't like the new funds so I transferred my money to an IRA before it was transferred to the new owner's plan. Getting your money out of a 401(k) years after you leave can be a bit of a hassle, particularly if the company goes through major changes. Former employees don't get the same level of attention as active employees at many companies.

Related Reading Market Downturn Increases Scrutiny of Plan Investments, Education Ted's Table, Dec. 20, 1999: How should an employer deal with a worker who over-contributed?

Changing to an IRA requires making a number of decisions that can be avoided by letting the money sit in the 401(k). Some people prefer to leave the money in the 401(k) because they don't like having to make these decisions. However, you will probably ultimately have to take the money out of the 401(k).

Are you likely to be better equipped to deal with this change now or later? All of these issues should be factored into your final decision. As I mentioned earlier, there isn't any big rush unless you are approaching the age when you will be required to take the money out of the 401(k). This varies by plan, but many use age 65.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every other 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.

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.

Ted's Table

Technical Terms Early withdrawal penalty Employee Retirement Income Security Act Plan document

TB: The ultimate responsibility falls on the employee, but the employer also plays an important role. The employer is required to ensure that the limit isn't exceeded but this can be difficult if an employee contributes to two plans in the same year. When the annual dollar limit is exceeded, it is up to the employee to inform the employer of the excess contribution and to request a refund of the excess plus applicable investment return. This notice must be filed with the employer by March 1 following the year the excess was contributed.

You may wonder why the employee has to inform the employer. It is increasingly common, due to shorter eligibility waiting periods, for an employee to be able to contribute to two plans during the same year as a result of a job change. The potential for exceeding the limit is increased whenever contributions are made to two employers during the same year, because the second employer has no way of knowing how much the employee contributed to the first plan.

The employee has the right to decide which plan should refund the excess amount. This is why the employee must inform one of the employers of the excess amount. The excess must be refunded by April 15th of the year following the year that it was contributed. The employee has a good reason to make sure the refund is made in a timely fashion — if the April 15th date is missed this amount must be left in the plan until it can be distributed as a benefit distribution payment. It will be taxed twice: once during the year it is contributed and again when it is distributed.

I have addressed which plan should make the refund in previous columns. Generally, I recommend that you ask your former employer to make the refund.

TB: You are right on target. Some participants want complete investment flexibility but many participants have great difficulty picking from just a few funds. Despite this apparent conflict, I believe the number of plans offering unlimited choice will continue to grow as employers respond to pressure from those vocal participants who will not be satisfied with anything less.

I am concerned about what happens to those quiet participants who are struggling to handle this responsibility. I am also concerned that many participants, looking at the extraordinary market returns achieved during the 1990s, have very unrealistic expectations about what this new freedom will get them.

Building an adequate retirement nest egg requires both saving and investment discipline over an entire working career in most instances. As you have pointed out, wanting to get there the fast, easy way tends to lead to emotional rather intelligent investing. Sometimes people get lucky and break this pattern but it isn't a very solid way to build a retirement strategy.

TB: Legally, after-tax contributions may be withdrawn any time for any reason as long as the plan document permits doing so. There isn't any reason for tying the withdrawal of after-tax contributions to hardship withdrawals. The primary reason for having after-tax contributions is to give participants easier access to these funds than is possible with pre-tax contributions. Frankly, I have never heard of a plan that limits the withdrawal of after-tax contributions to financial hardships. But, it is possible.

When after-tax contributions are withdrawn, it is also necessary to withdraw the applicable investment gains. The investment income that is withdrawn is fully taxable.

Your question regarding the applicable tax to withhold is an interesting one. Hardship withdrawals are subject to 10 percent tax withholding on the taxable portion. Other distributions are subject to 20 percent mandatory tax withholding. In my opinion, the 10 percent rate would apply if the withdrawal of these contributions were really subject to the hardship withdrawal rules according to the plan document. Of course, the employee must ultimately pay tax on the investment income that is withdrawn based upon his personal tax rate plus the 10 percent early withdrawal penalty tax.

Question: Does a 401(k) provide a higher level of protection than an IRA against civil lawsuit judgments and other types of asset-attachment actions? The major fund companies never seem to discuss this aspect of the two retirement savings options when they present reasons to roll a 401(k) account at a former employer into an IRA. Yet, as my husband and I build substantial retirement assets, I've become more aware of how litigious society has become. If the investment options within my former employer's 401(k) are good, as mine are, why roll over the money to an IRA?

TB: You do have a somewhat higher level of protection from legal claims when you leave the money in a 401(k). The money held in 401(k) plans is protected by the Employee Retirement Income Security Act. This is an advantage if you are worried about litigation. IRA assets, on the other hand, are covered by state laws. Not all states have laws protecting IRA money and those that do may not be uniform with other states.

There isn't any reason to rush to roll the money into an IRA if you are satisfied with the investments and if your employer is stable.

The fact that the situation can change rather quickly, however, is a factor to consider. Your employer can change the investments at any time either by moving the plan to a new service provider or if the business is sold.

I speak from experience. I left some retirement money with a former employer because I was comfortable with the investments. The company was sold about a year after I left. I didn't like the new funds so I transferred my money to an IRA before it was transferred to the new owner's plan. Getting your money out of a 401(k) years after you leave can be a bit of a hassle, particularly if the company goes through major changes. Former employees don't get the same level of attention as active employees at many companies.

Related Reading Market Downturn Increases Scrutiny of Plan Investments, Education Ted's Table, Dec. 20, 1999: How should an employer deal with a worker who over-contributed?

Changing to an IRA requires making a number of decisions that can be avoided by letting the money sit in the 401(k). Some people prefer to leave the money in the 401(k) because they don't like having to make these decisions. However, you will probably ultimately have to take the money out of the 401(k).

Are you likely to be better equipped to deal with this change now or later? All of these issues should be factored into your final decision. As I mentioned earlier, there isn't any big rush unless you are approaching the age when you will be required to take the money out of the 401(k). This varies by plan, but many use age 65.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every other 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.

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.