New Tax Law Wrinkle Affects Employer Payouts
Workers who get fired or change jobs must be far more careful about how they take their pension payouts, thanks to a new wrinkle in the tax law brought about by recently passed unemployment compensation legislation.
The point of the unemployment bill, signed by President Bush early this month, was to extend jobless benefits for those who have been out of work for more than six months. But since providing additional unemployment benefits costs money and the government is strapped for cash, legislators needed to find a way to pay the tab.
What Congress came up with is Byzantine. It takes this one group of taxpayers--those who are leaving or switching jobs--and says that if they don’t leave their retirement money in the former employer’s plan or have it transferred directly into another tax-deferred plan, the money is subject to 20% withholding. That doesn’t increase Uncle Sam’s tax revenues. It just lets the government get its hands on the money quicker.
The practical result for an individual is this: If your employer writes a check to an administrator of an individual retirement account, the IRA administrator gets a check for the full value of your account. To illustrate, let’s say your pension is worth $50,000. But if your employer writes that check to you, you get only $40,000 because of the 20% withholding. If you want to roll the whole amount into an IRA, you must make up the $10,000 difference if you didn’t have it sent directly.
If you do roll the entire amount into an IRA, you’ll get the $10,000 back when you file your tax return the next April. If you don’t roll the money into an IRA, you’ll get slapped with taxes and penalties--the same as before. If you roll only the amount of cash you get--the $40,000--into an IRA, you’ll pay tax and penalties on the $10,000 that was withheld.
“Now, if employees are not sure what they want to do when they are leaving, some of the distribution will be withheld. As a practical matter, that may mean they lose the right to roll the whole amount over because they may not have the cash to do it,” said Paul Strella, principal at the employee benefits consulting firm of William M. Mercer Inc. in Washington.
In other words, the law puts a premium on planning. Individuals must decide not only whether they want their pension funds to be rolled into an IRA, they have to decide where and how to invest it. And they have to make some of those decisions before they leave their company--or at least before the company sends out a check.
Luckily, there are some simple answers for those who were delaying solely because of such unanswered questions. To wit:
1. Should you roll your pension money into an IRA?
Yes.
2. Why?
If you don’t, you’re going to lose about half of the money to state, federal and penalty taxes.
3. What if you need the money to live on while seeking another job?
Roll it into an IRA anyway. Then take out what you need when you need it. That way, you pay tax only on the amount you spend.
4. What if you aren’t sure how you want the money invested? After all, there are literally hundreds of banks and brokers who offer IRA plans, and the fees, services and investments they promulgate vary widely.
Park the money in a low-risk, low-cost IRA while you make your decision.
5. How do you find such an account?
Look around. They’re everywhere. Low-risk accounts include those that invest in federally insured certificates of deposit and short-term Treasury bills. They’re available through most banks, thrifts, brokerage firms and mutual fund companies.
The best way to find a low-cost account is simply to call around.
The results of an informal survey: Discount broker Charles Schwab has a limited-time offer for those with $10,000 or more to roll into an IRA: No fee for life. If the IRA is worth less than $10,000, the fee is currently $22 annually. Fidelity Investments, the Boston-based mutual fund company, has a $10 IRA fee. Great Western Bank, a Los Angeles-based thrift, charges between $15 and $25, depending on the type of account. Bank of America charges $8. At Citibank the charges vary depending on where you live. It’s $7.50 in California; free in New York.
If you’re unable to find a low-risk, low-cost account before you leave your job, see if your former employer will hang onto your money for a while. Many employers will agree to delay distribution of retirement funds for indecisive employees. And generally, there’s no charge for the service.
In time, however, you will need to determine how to invest your retirement money for the long haul. And this question has no easy answer. You should consider how much you have, how much you’ll need at retirement and how comfortable you are with taking risks. Your ultimate plan should be as individual as your fingerprints.
