April 4, 2000
This Week, Ted Tackles:
How do I manage my early retirement withdrawals?…I have a job offer with a great employer-matching contribution but lousy salary. Is this a good deal?…How are 401(k) and insurance premium deductions made?…What guidelines should I use to select a 401(k) provider?…How will my beneficiaries deal with my 401(k) after I die?…Comparing SIMPLE IRAs with 401(k) plans.
Question: I want to take advantage of an early retirement option at age 55, continue to work part time, and move to my weekend home. My questions are as follows:
May I take distributions from my 401(k) plan to supplement my income based on my tax bracket at that time? Will there be any penalties? Is there any stipulation to make 401(k) withdrawals after age 55? Would I be forced to take installments or withdraw certain amounts on a yearly basis thereafter, as in an IRA? May I take a random yearly amount based on my current needs and not be penalized?
TB: The key to avoiding the 10% early withdrawal penalty tax is to leave your employer after you reach age 55. There isn't any requirement that you must stop working. You can move to your weekend home and work part time for another employer without fear of this penalty tax.
Legally, you may withdraw whatever amount you want between the ages of 55 and 70½. Withdrawals after age 70½ must be sufficient to satisfy the required minimum distributions.
The major stumbling block will be the distribution provisions of your employer's plan. Most 401(k) plans permit only lump-sum distributions because installment distributions are more expensive to administer. You need to check whether your plan requires lump-sum distributions. If it does, the only way you can take money out each year between age 55 and 59½, without triggering the 10% penalty tax, will be to roll the money into an IRA and to take equal annual distributions that meet the annuity rules.
Question: I have an opportunity to work for a company that offers a matching contribution of $2 for each $1 I put into my 401(k) plan. There is no vesting period. The problem is the base salary is way below market. First, would you consider saying yes to this situation yourself? Second, what is the math for determining how much of a benefit the 401(k) matching is when you consider the federal limits? What are the 401(k) federal limits?
TB: A 401(k) with a $2 per $1 match is wonderful but you certainly need to factor the lower pay into your decision. The maximum amount you may contribute is $10,500. The combined employee/employer maximum is 25% of pay, not to exceed $30,000. The employer match usually is limited to a maximum such as the first 6% of pay you contribute. Let's assume your plan contains such a limit and your salary will be $70,000. You will receive $8,400 of matching contributions if you contribute $4,200 (6% of your $70,000 salary).
The key to your decision is the amount of the salary differential compared to the employer match. If the salary differential of your current job is significantly more than the amount of matching contributions offered at the new one, you should keep your job, everything else being equal.
Question: What's the sequence for deducting a weekly 401(k) contribution and an insurance premium through Section 125? Is the 401(k) contribution deducted from the gross wages, then the insurance premium, or vice-versa? Or, is it up to the payroll department?
TB: Both 401(k) and Section 125 contributions usually are computed starting with gross pay, pre-401(k) and pre-Section 125, contributions. For example, assume your gross pay is $3,000 per pay period, 6% is deducted for 401(k), and $125 is deducted for Section 125. The 401(k) deduction would be $180 and $125 would be deducted for Section 125, leaving $2,695 of net income subject to federal income tax.
The key is how compensation is defined in the 401(k)-plan document. Compensation should be defined as gross pay, pre-401(k) and pre-Section 125 deductions, and any employer contributions should be computed using this amount. This is the compensation formula most plans use.
Question: Can you give me some guidelines on how to choose a 401(k) company or fund family? There are so many investment companies, brokers, and third-party administrators in the market. My company has an existing plan but is looking to switch to a plan with higher performance and lower administrative costs. Of what should I be aware? How do I really compare the fund performance? Is there anything else I should consider, such as fees, loads, etc.
TB: The general legal requirement of ERISA (Employee Retirement Income Security Act) is to make your decision considering solely what is in the best interest of the participants. The following are the factors I would consider. There isn't any significance to the order in which these items appear. I recommend starting the search process by identifying the things that are most important to you, then evaluating the providers using these factors. My suggested factors are:
A. Are 401(k) plans and services a major part of the provider's business?
B. Does the provider have a large enough 401(k) client base that is likely to be a long-term survivor in a tough market?
C. If your plan has any unusual provisions, does the provider have experience handling plans with similar circumstances?
D. What is the provider's target market? What percentage of its client base is similar to the size of your plan?
E. What support services does the provider give participants? For example: investment education, investment advice, 24/7-Internet access for information and to conduct transactions, on-site educational meetings, etc.
F. How robust is the recordkeeping system? Does it operate from a single database in real time so that anyone accessing the system from any location, and for any reason at the same time, will see the same information? What are the levels of redundancy?
G. What are all applicable fees, including investment, administrative, transitional, etc., and who receives the money? You should insist on knowing how much all the various players involved will be paid. Remember, no one works for free. Your company or your employees will pay everyone involved.
H. What's the range of available funds - single or multiple family?
I. What is the quality of the funds? Are they proprietary funds or are they independently managed funds selected by the provider? If they are independent, what standard does the provider use to select and/or replace managers?
J. Do you like the team that will be assigned to manage your plan? How long have they been in the business? How long have they been with this provider?
L. How many clients has the provider lost during the last twelve months and what were the reasons?
K. Ask for references including some clients that left the provider during the last twelve months.
Investment performance certainly should be a key factor but you need to look beyond the mere numbers. You need to consider style consistency, risk taken, etc. I would stay away from a provider that charges added investment-related fees other than the standard fund-investment-management fee. This would include front-end, back-end, and wrap fees that are in addition to the fund-management fee. You should consider using a consultant to help you if you do not have in-house talent that is experienced in these matters.
Question: I know there are legal requirements that generally force a beneficiary to take the money out of the 401(k) and a beneficiary isn't allowed to roll over an inherited 401(k) to his or her own 401(k). Is a beneficiary forced to take a lump-sum distribution for the whole 401(k)? Does it pay to roll 401(k) money into an IRA, so a beneficiary can extend the minimum required distributions (depending on their age), rather than having the beneficiary get hit with lump-sum payment on death?
TB: In most instances, where the spouse is the beneficiary, the best option is to roll the 401(k) balance directly into an IRA rather than to take a lump-sum distribution. This will enable the spouse to take periodic distributions and to preserve the tax-deferred growth on the remaining balance. A lump-sum distribution usually is the only option available to other beneficiaries.
Question: I'm researching the possibility of starting a salary-savings program for my company's employees. I read that one advantage of a 401(k) plan over a SIMPLE IRA is that 401(k) distributions are eligible for averaging provisions. What exactly are averaging provisions?
TB: The income-averaging provisions have been eliminated so they aren't an issue. Even if they still existed, they shouldn't effect the decision you're trying to make.
A SIMPLE IRA does not charge any installation or administrative fees. You also avoid all the compliance hassles of a standard 401(k) plan. There is a minimum required employer matching contribution equal to 1% of pay during the first two years with a SIMPLE, but this amount probably will be less than the fees that have to be paid with a 401(k). However, the maximum allowed employee contribution is lower than for a 401(k), at $6,000 instead of $10,500.
401(k)s generally don't work well without a matching contribution. I would recommend the 401(k) if the highly compensated want to contribute $10,500 instead of $6,000, and if the contribution levels of the non-highly compensated employees are likely to be sufficient to permit this larger contribution. Due to the special non-discrimination tests, the highly compensated employees frequently are permitted to contribute only 5% or 6% of pay with a standard 401(k).
A strategy I recommend for many small start-ups is to use the SIMPLE IRA, with a 1% matching contribution for two years, then to consider a standard 401(k).
Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing
questions every week. 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.
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