Wake up hibernating 401(k)s

By Scott Wheeler


Join other financial professionals that are creating solid sales opportunities by helping clients awaken old retirement plans and move them away from an ex-employer. For the client, moving these plans out from under the purview of an ex-employer can be a freeing exercise, and it can also open up additional options not currently available, if left snoozing.

When you consider that, on average, individuals change jobs about every seven years, and you add to that the popularity of 401(k) plans, it's quite possible that by knowing more about this particular transaction, you will capture additional sales. Want an easy example of how this can work? Simply adjust what you do and include questions surrounding this topic as a standard discussion item during initial interviews and annual reviews.

If a client (or spouse) has changed jobs in the last five years, chances are at least one of them had a 401(k), and there's a good chance it was just left there and more or less forgotten about.

Is it spring yet? In order to help prospects and clients understand what they could gain by waking up their hibernating 401(k) account, let's take a look at some of the reasons why moving an old 401(k) away from the "den" of an ex-employer is a good idea.

Increased investment options. The average 401(k) has just 181 investment options, as opposed to the almost limitless amount of investments provided by IRAs, including fixed index annuities.

Professional advice/poor service from benefits department of employer. Many benefits departments are not very helpful when it comes to making recommendations or servicing an account. It is much easier for a professional to service the client's funds once they are in an IRA.

Bankruptcy law changes. Since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, funds in any type of IRA have as much bankruptcy protection from creditors as those in 401(k)s, including when the money is in-transit.

Note: IRA account values do not have the same judgment protection as 401(k)s do.

Legacy planning and beneficiary options. Company plans have limited options for passing money along to heirs. Although 401(k) plans can now take advantage of the same "stretch" rules as IRAs, 401(k) plan administrators rarely take on the additional administrative expenses. Also, keep in mind that unlike IRAs, 401(k) plans have stringent rules requiring spousal beneficiary signatures.

A case for more sleep? To be sure, there are a couple of reasons why a 401(k) account should not be shaken from its cave and moved into an IRA. The first situation is if the client has highly appreciated employer stock in their 401(k). Secondly, if there's a chance they may want to withdraw money from the plan before age 59½. Let's take a quick look at both situations.

Net Unrealized Appreciation (NUA). This situation arises when the qualified account holds highly appreciated employer stock. Company plans that contain employer stock can gain special tax treatment on the net unrealized appreciation inherent within the employer stock.

The tax break is based on the difference between the cost basis and the stock's fair market value when the company shares were distributed. This component is eligible for capital gains treatment at the time of sale, as long as the client paid tax on the basis at the time of distribution. Once the qualified account is moved to an IRA, this potential tax break is gone for good and cannot be restored.

Age 55 exception. This situation arises when your client is in need of income before age 59 ½. Keep in mind that the 10 percent withdrawal penalty does not apply to a distribution made from a qualified employer account to an employee after separation from service during or after the year in which age 55 is attained.

To qualify for this exception, the client must separate from service with that employer during or after the calendar year in which they reach age 55. Additionally, the client must take a lump sum distribution of all of the assets in their employer sponsored account by the end of that tax year.

Unneeded funds can be rolled over to another qualified account. If allowed by the employer plan, the distribution can include funds that were rolled into the employer sponsored plan from a former employer's plan.

The age 55 exception does not apply to distributions made from an IRA, even if the client had rolled funds into the IRA from an account that qualifies for this exception.

Finally, under the Pension Protection Act of 2006, qualified public safety employees that have separated from service can use this exception at age 50 or later, rather than at age 55 or later.

Keys to success checklist:

401(k)s to IRAs:
  • Ask clients about dormant 401(k)s, company stock in 401(k)s, and the age 55 exception issue.

  • Make client aware of the advantages of moving a 401(k) plan.

  • Be aware of IRA and 401(k) bankruptcy protection rules.
Age 55 exception/NUA:
  • With the company at 55?

  • The client must have worked for the company whose plan the money is being withdrawn from at some point during the year that age 55 was attained. If this is not the case, a 10 percent withdrawal penalty would apply.

  • If the client wants to withdraw part of the funds from the qualified plan, they are required to rollover the remaining funds before the end of that year. Any funds needed can be withdrawn from the plan without penalty before rolling the remaining balance.

  • Does the account contain highly appreciated employer stock?
401(k)s to IRAs:
    1. 401(k)s offer judgment protection, IRAs do not

    2. If a client is at risk for civil suits, be aware that a 401(k) would offer protection not provided by IRAs.

    3. Net Unrealized Appreciation (NUA)
Age 55 Exception:
    1. Lump-sum distribution in same tax year

    2. All of the assets with qualified plan must be distributed during the tax year that a payment is taken under the age 55 exception.
1.U.S. News and World Report, October 2009.

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