This week, Gail addresses the new portability rules for 401(k)s and taxation rules for withdrawing money from a 401(k) early to pay hardship costs. 

Hi Gail, 

We're in the process of setting up a 401(k) plan at my company. Our financial advisor tells us that there are several types of accounts that can now be rolled into a 401(k) plan -- no longer just the "qualified" funds, but now also "non-qualified" funds as well. This would mean that a person can roll a standard IRA into a 401(k) plan without disqualifying the plan. Is this correct? It sounds too good to be true. 

Thanks, 

Sabra 

Dear Sabra, 

The Tax Relief and Reconciliation Act of 2001 was a welcome breath of fresh air for retirement plans. Not only does it greatly simplify many arcane rules, it also allows both employees and their companies much more flexibility. This includes making it easier to consolidate your retirement assets so your retirement funds won't be scattered among a conglomeration of company plans from previous employers and multiple IRAs. 

For instance, imagine you go to work for the city police department when you get out of college. There you have a retirement plan called a "457." After 20 years, you retire from the force and go into private security work for a corporation that offers its employees a 401(k). After 10 years, you want to cut back a bit on your work schedule, so you leave that company to teach law enforcement at the local community college, which has a 403(b) plan. 

Assuming all of your contributions were made on a pre-tax basis, "theoretically" the new law would allow you to roll your 457 balance into your 401(k) and then roll that into your 403(b) as you change jobs, even though a 457 plan and a 403(b) are not technically "qualified" retirement plans and a 401(k) is.* Depending upon the terms of your 403(b) plan, you could roll that into an IRA when you retire from teaching, even though an IRA is not a "qualified" retirement plan, either. 

Naturally, keeping all of your retirement funds in one place makes it easier for you to manage them. Instead of statements coming from all current & former employers, you just get one. You'll only have to keep track of one plan rather than several, so you'll be better able to monitor the performance of your investments. 

In the industry, the ability to move a retirement account when you change jobs is known as "portability." However, in order for this to occur, your employer's plan has to be amended to allow workers to roll in retirement balances from other plans. In other words, just because the federal government allows portability, a retirement plan does not have to offer it. Furthermore, if a 401(k) is also going to accept after-tax contributions originally made to another plan, it must have a system in place to separately account for these dollars. 

An additional system means additional expense. As a practical matter, most companies are not anxious to spend the time and money required to make this available to their employees. That's why I say in "theory" this is how it works. And while I applaud your firm for considering this, you need to understand that it will make administering the plan more complicated and, thus, more expensive. 

Moreover, there is a simple and cost-effective alternative: employees can just roll their retirement dollars into an IRA when they change jobs. All pre-tax money can be moved into a traditional, tax-deductible IRA. After-tax contributions can also be rolled into a traditional IRA, but if you do this, be sure to file Form 8606 so you're not taxed on this money when you withdraw it later. 

The main drawback to rolling retirement plan money into your IRA is that it might not have the same level of creditor protection as it did in your company retirement plan. Thanks to federal law, a "qualified" plan is generally off-limits if, say, you file for bankruptcy. However, IRAs get their protection from state law, which varies based upon where you live. Some states have enacted legislation that mirrors federal law, but some only protect your IRA up to a certain amount. In Vermont, it's $10,000. If you are sued in California and lose, you can be required to cough up all of your IRA except an amount the court considers necessary for the support of yourself and your dependants. 

Don't let this scare you. Unless you're in a profession that is prone to lawsuits or you are contemplating filing for bankruptcy, this shouldn't deter you. And an IRA offers greater flexibility for both you and your beneficiaries and makes the most sense for the average person. 

So, your financial advisor is correct. But be sure your company understands the financial and administrative ramifications of offering to accept retirement money from other plans. 

Good luck! 

Gail 

 

*Technically, for a plan to be considered "qualified," it has to derive its tax-deferred status from Section 401(a) of the tax code. 

Hello Gail, 

I have a question regarding an early withdrawal from my 401(k) plan a couple of years ago. Because I was in my early 50s when I withdrew the money, I had to pay a 10 percent penalty. 

A few months later I had to pay $20,000 to a hospital because of an illness. Because a portion of my 401(k) was used to pay this bill, is there any way that I can recover the 10 percent penalty on this portion of the payout? 

I hope this makes sense and would appreciate your response. 

Thanks, 

Leonard 

Dear Leonard, 

Many company retirement plans allow you to withdraw money while you are still an employee and before you are age 59 ½ for "hardship" reasons. Paying expensive medical bills would clearly qualify. However, a "hardship" does not excuse you from paying income tax on your withdrawal nor does it automatically mean you can escape the 10 percent penalty for an "early" (pre-59 ½) withdrawal. All a hardship withdrawal does is give you access to your money in the plan. 

However, although you might have intended to use your 401(k) withdrawal for another purpose, if you ended up using an amount equal to all or part of it to pay for medical bills that year, you could be entitled to some relief. 

If this was the case, you would still owe income taxes on your withdrawal. However, they would have been mitigated to the extent your medical expenses were higher than 7.5 percent of your Adjusted Gross Income (AGI). You should have taken the amount over this threshold as a tax deduction in the year of your withdrawal. 

In addition, to the extent your withdrawal was used to pay for this "overage" (i.e. the amount over 7.5 percent of your AGI), it would not be subject to the additional 10 percent penalty for an "early" (i.e. pre-59 ½) distribution. Unfortunately, time is running out. You can only go back three tax years to file an amended return. I strongly suggest you find a competent tax preparer who can file the appropriate paperwork in a timely manner for you. 

Good luck, 

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.