If you are a 401(k) plan owner, imagine how you would feel if you were on a sinking cruise ship and couldn’t get off because there weren’t any life jackets or backup boats. Now ask yourself, if you were going to potentially face this scenario, when would you want to know about it?
If you have money in a 401(k) plan, you could find yourself in this situation if your plan gets frozen in what is called a blackout period and the markets decline. During a blackout, which occurs when a company decides to make changes to the record keeper, participants are locked out of making investment changes to their plan. This has recently happened with several large employers in the area like Westar, Stormont Vail, and St. Francis. While blackouts don’t happen frequently, they can last a few weeks and we’ve seen them last several months in extreme cases. Fortunately, many people with a 401(k) plan may avoid this potential issue by using what is called an In-Service Distribution.
Is an In-Service Distribution right for you? First, determine if your company retirement plan offers In-Service Distributions if you are still employed. Most plans do for people over the age of 59 1/2 or if they meet certain other requirements. If you qualify, consider the advantages and disadvantages of potentially rolling over your money to an Individual Retirement Account (“IRA”), which not only makes it so you don’t have to worry about a blackout, but also increases the number of investment options available to you. With more options available, you can better control the fees you pay instead of being at the mercy of paying whatever fees your retirement plan at work charges. Recently someone was in our office for a 3 Step Retirement Review and we found the total fees they were paying in their 403(b) (similar to a 401(k), but for a non-profit) to be over 4% per year! It is difficult to get ahead if your performance is weighed down with fees that are that high. We’ve also seen examples, though, where 401(k) fees are quite low and investment options quite good. In these cases, we typically tell people to keep money in their 401(k) unless tax planning makes sense for their situation.
With tax rates set to automatically rise after 2024 (because of a sunset provision in the Trump tax cuts) action now while tax rates are lower may be a reason to consider a rollover to an IRA. Money in an IRA can be converted to a Roth, either all at once or slowly each year, which could potentially save thousands in taxes over time. With a Roth conversion you pay the taxes now on the amount transferred to the Roth at the current historically low tax rates, but then you’ll never have to pay taxes on the withdrawals from the Roth or its growth in the future. Even if tax rates don’t rise a conversion can still save a retiree a significant amount in taxes. Taxes work very different in retirement and its possible you can pay a higher effective tax rate on 401(k) or IRA withdraws later even if your income in retirement is lower. While this is completely counter-intuitive, it is unfortunately a reality that a retiree can face as outlined in our June and July articles “Getting the Taxman Out of Your Retirement.” To see how much, if any, sense it makes to convert to a Roth you should seek out the guidance of a professional that can run a ‘tax map’ to show you what your taxes are likely to be in the future for any IRA or 401(k) account withdrawals versus what they would be now if taken out and converted to a Roth. This is analysis that should be run each year to calculate how much can be converted now at a tax lower than what you would likely pay in the future. This can sometimes be a small amount, but it can also be a larger amount depending on your situation.
If you are considering making such a conversion from a 401(k) plan to a Traditional IRA or Roth IRA you should also consider setting it up as a ‘stretch IRA.’ What stepping up to a ‘stretch’ does is allow you to pass on your assets to your heirs and keep them in a Traditional IRA or Roth instead of having to pay taxes on the lump sum at death. This strategy may save a family over 42% in taxes if the lump sum when added to your heirs other income were to cause them to land in the top federal tax rate of 37% and top Kansas tax rate of 5.7%.
If you’re not sure if you can take an In-Service Distribution from your 401(k) plan or if you are unsure if you are one of the many that could save thousands in taxes by converting to a Roth and/or a ‘stretch IRA’ account, consider having your personal situation reviewed by an independent investment professional that is familiar with the Pension Provision Act and advanced tax reduction planning. With an election next year, the tax code may change even before 2024, so doing planning this year may be even more important. Actions taken this year (or inaction taken this year) could be one of the most impactful things in determining how many individuals will live out their retirement years and the taxes they will pay in the future.
–Ryan Shumaker, Smartvestor Pro at The Retirement Team