Ask the advisors: 401(k)s; teaching kids to save

Dear Advisors:

I'm planning to switch jobs. What can I do with the money that's in my 401(k) once I leave?

If you expect to retire soon or you are switching jobs, you may be in line to receive a substantial payout from a qualified retirement plan. What should you do with all the money? There is no exact right or wrong answer. Consider these four basic options:

1. Take the money and run.

Remember that a lump-sum payout is taxed at ordinary income rates (reaching as high as 35 percent). Also, you generally are required to pay a 10 percent penalty tax – on top of the regular income tax – for distributions made before age 59 1/2.

However, if you were born before 1936, you may qualify for special income averaging. In effect, the distribution is taxed as if it is being spread out over ten years (plus favorable capital gain treatment may be available).

2. Receive annuity-type payments.

By choosing to receive a series of payments, you effectively spread out the tax liability over time. Typically, the payments are based on your life expectancy or the joint life expectancy of you and your spouse. The payments end upon the death of the surviving spouse.

3. Leave the money in the plan.

If permitted, you can leave the money right where it is – in the plan of your former employer. The funds in your account may still provide earnings without any current tax erosion. However, it may be difficult to manage the funds or gain access to them, especially if you are leaving on bad terms.

4. Roll over to another plan or IRA.

Instead of taking out cash, you can elect to roll over all or part of your account balance to another qualified plan (say, the plan at a new employer) or an IRA. If the rollover is completed within 60 days, there is no current tax liability on the transfer. Then you can take withdrawals of cash as needed, subject to regular income tax.

But there's a catch: The IRS requires your former employer to automatically withhold 20 percent of a lump-sum distribution to offset your potential tax liability. To roll over your entire account balance, you must come up with 20 percent of the amount out of your own pocket. Then you can recoup this amount when you file your tax return.

This result can be avoided by arranging a trustee-to-trustee transfer in which the cash never touches your hands. In that case, you avoid the 20 percent withholding rule.

Dear Advisors: How can I teach my children to save for the future?

Inform them about the benefits of a Roth IRA. In fact, you can have them set up a Roth IRA just as soon as they earn their first full-time wages.

Even though the contributions are nondeductible, Roth IRAs have several attractive features not offered in traditional IRAs. Most important, the earnings within a Roth IRA compound tax-free rather than tax-deferred. Also, one can withdraw the funds after age 59 1/2 without paying income taxes as long as the account has been open at least five years.

Roth IRAs have become popular investment vehicles for many people who want to save, but they work especially well for those who start at a young age. Availability of Roth IRAs is restricted for certain high-income individuals, but this generally should not be a problem for younger workers.

Although your children might not get overly excited about saving for a retirement that may be 40 or more years away, the flexibility of Roth IRAs makes them especially beneficial for various other purposes.

Your children's contributions to a Roth IRA can be taken out anytime without taxes or penalties. The contributions and earnings are available for college expenses, but taxes will apply only to earnings withdrawn. In addition, five years after the account is opened, your children can use up to $10,000 to buy their first homes and not pay taxes or penalties.

There is no minimum age required to set up a Roth IRA. The maximum allowable contribution is based on earned income, not investment income.

As long as your child is a minor, you'll control the account. But once your child reaches your state's age of majority, the Roth IRA belongs to him or her, and you cannot impose restrictions on how your child spends it. Nevertheless, show your child how the money would grow over the years and review the fund's reports. Over time, your child will see the account grow and begin to appreciate the benefits of saving for the future.

Kerry Nelson, CPA, tax manager for The Rehmann Group, is located in the Traverse City office; kerry.nelson@rehmann.com.

Ryan Sullivan, CFP®, PRP™, is a financial advisor for Rehmann Financial and is located in the Traverse City office; ryan.sullivan@rehmann.com.

Advisory services offered through Rehmann Financial, an SEC Registered Investment Advisor. Securities offered through Triad Advisors, Member FINRA/SIPC. BN

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