Employee Fears She Might Be Forced to Cash Out 401(k) Account When She Quits

Q: A co-worker is voluntarily leaving our company soon.

She has participated in the 401(k) plan here for years and wonders if she is required to cash out her account upon leaving the company. She is worried because she has no place to put the money and wants it to continue to earn tax-deferred interest on her behalf. She has been told that if she withdraws her funds, they will be heavily taxed. What’s the real situation?

--D.N.

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A: Under federal law, if a 401(k) account contains more than $5,000, the account holder may leave it with his or her old employer until reaching the retirement age specified in the company’s 401(k) plan or age 62, whichever is later. So, no, there is no requirement that your co-worker cash out her account if it contains more than $5,000. (If it’s less than that amount, the company has the right to cash out the employee without his or her consent if the plan gives it that option. And most companies’ plans do contain this option.) But be advised, once the employee leaves the company, there can be no new contributions to the account. Still, the account will continue to accumulate tax-deferred interest.

However, your co-worker has more options available to her than simply leaving it with her old employer. If she has a new job that offers a 401(k) plan, she may be permitted to transfer the proceeds from her first account to the plan of her new employer. Exactly when that transfer can be made and under what circumstances will depend on the rules of the new employer’s 401(k) plan. And even if she doesn’t have a new 401(k) plan to enroll in, she may certainly transfer the proceeds into what is known as a rollover individual retirement account. These IRA funds can be invested in myriad places, ranging from something as simple as a passbook savings account at a bank to any one of the thousands of mutual funds or stocks offered by brokerages.

But be advised that employees cashing out of their old employers’ 401(k) or other qualified pension plans face a 20% withholding tax on the disbursement if they take direct possession of the money rather than having it transferred to another qualified employer pension plan or IRA. This is probably the “heavy” taxation your co-worker was told of. But it is completely avoidable. All a taxpayer must do is ask that the 401(k) funds be transferred “trustee to trustee” from her company’s plan to her new IRA. So long as she never takes possession of the funds, they will not be subject to any taxation as a result of the transfer.

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Q: Different writers have offered different explanations on how to spread the taxes due on Roth IRA conversions made this year. Two weeks ago, you said the income from the conversion is spread over four years. Others say the actual taxes based on the conversion-year income are spread over four years. Who’s right? The correct answer may make a big difference to many taxpayers.

--N.Q.

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A: The correct answer is that the income is spread over the four-year period the law allows. So, let’s say that your IRA has, for simplicity’s sake, $200,000 in it and you convert it this year to a Roth because you meet the requirement of having an adjusted gross income of less than $100,000. You would add $50,000 to your taxable income in each of the years from 1998 through 2001. (By the way, the $50,000 you would add to your 1998 income would not count toward the $100,000 ceiling on adjusted gross income that determines whether you are allowed to make the Roth conversion.)

Further, the $100,000 ceiling on adjusted gross income for the conversion applies only to 1998, the year in which the conversion is made. So, if you can meet the requirement this year, that’s all that matters. If your income is higher in any of the next three years, it doesn’t count. You made the conversion and are entitled to spread out payment of the resulting taxes over four years.

By the way, this approach of spreading out the income over four years may mean that some taxpayers will pay more tax on the converted IRA because they may be in a higher tax bracket next year than they are in this one. That is precisely because they moved to keep their 1998 income artificially low to qualify for the four-year tax treatment of the conversion.

These considerations should be taken into account when determining whether a Roth conversion is appropriate to your individual tax situation.

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Carla Lazzareschi will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com