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My wife quit her job of 14 years last December. She has about $50K in a 401(k) plus some in a state-run retirement account.

First, I looked up something on the FAQ/Notes for Retirment Investing that said:
"State and local governments are prohibited from offering 401(k) plans to their employees. This was once true of private, tax-exempt employers as well; however, as of January 1, 1997, the latter may now establish a 401(k) plan for their qualified employees."

Well, both my wife and I have 401(k)'s as employees of city governments. Why does the FAQ say this?

Second, what are the pros/cons for rolling over her 401(k) into an IRA?

Thanks,
Chris
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My wife quit her job of 14 years last December. She has about $50K in a
401(k) plus some in a state-run retirement account.

First, I looked up something on the FAQ/Notes for Retirment Investing that
said:
"State and local governments are prohibited from offering 401(k) plans to
their employees. This was once true of private, tax-exempt employers as
well; however, as of January 1, 1997, the latter may now establish a
401(k) plan for their qualified employees."

Well, both my wife and I have 401(k)'s as employees of city governments.
Why does the FAQ say this?

Second, what are the pros/cons for rolling over her 401(k) into an IRA?

Thanks,
Chris


If you are at least 59 1/2 you can roll it OUT of the 401k for about 15% and if 65, about 12% total tax in a Lump Sum Distribution. Does that compare favorably with your tax bracket where the mandatory withdrawals will be when your 70 1/2? After the distribution, you pay no taxes on the net amount, but you'll pay taxes on any income after the distribution whereas the IRA would continue without taxation until you take it out. It depends on whether you 'll need the money to live on before the first tax free step-up at death. Ed
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Greetings, Chris, and welcome. You asked:

<<My wife quit her job of 14 years last December. She has about $50K in a 401(k) plus some in a state-run retirement account.

First, I looked up something on the FAQ/Notes for Retirment Investing that said:
"State and local governments are prohibited from offering 401(k) plans to their employees. This was once true of private, tax-exempt employers as well; however, as of January 1, 1997, the latter may now establish a 401(k) plan for their qualified employees."

Well, both my wife and I have 401(k)'s as employees of city governments. Why does the FAQ say this?>>


As of 1/1/87 and through 12/31/96, tax-exempt employers were not allowed to adopt 401k plans. Some (a very few), though, had adopted 401k plans before 1987. Those plans were allowed to continue. Additionally, on 1/1/97 non-governmental tax-exempt employers were again allowed to adopt 401k plans. Evidently your employer is one of those that had a 401k plan in existence before 1/1/87.

<<Second, what are the pros/cons for rolling over her 401(k) into an IRA?>>

Around Fooldom we believe the biggest advantage is the broader selection of investments available in the IRA as opposed to the limited, often mediocre and costly, choices within most 401k plans. As to a disadvantage, as Edcosoft pointed out there are rare cases when simply taking the money and paying income taxes on the distribution may be appropriate. That option, though, requires close examination because it's contingent on a whole host of factors such as your income tax rate today versus that in retirement, your age today, your need for the cash for income, your overall net worth, and a few other things. If your spouse was over the age of 55 on separation, if you are in a 31% marginal tax bracket today and expect to stay there, and if you have no need for the cash in retirement, then you could cash out today to enjoy a minimum income tax burden on your family over your lifetime. However, before you take that step you should consult your tax advisor. For most folks, it simply is not a good option.
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"If your spouse was over the age of 55 on separation, if you are in a 31% marginal tax bracket today and expect to stay there, and if you have no need for the cash in retirement, then you could cash out today to enjoy a minimum income tax burden on your family over your lifetime.

Let me see if I understand some of this.

By taking a lump sum distribution the taxes would be
less than 20% for cap gains. The advantage is a smaller tax hit today versus a longer and higher tax hit in the future - assuming that my MTR stays at 31%.

I am not sure I understand the comment about not needing cash in retirement. An example might help me.

Let's say I take a $500,000 lumpsum distribution and
pay the 15% tax or ($75,000). Doesn't this now make any investment from the $425,000 my new basis. If I left it and took it on a yearly basis, I'd be paying 31% in taxes.

Is the concern the loss of the 401K or IRA tax shelter for future returns?

Is it possible to take a Lump Sum and roll that into
a ROTH which shelters future gains and withdrawal from taxes?

BGP
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Your quote is from PIXY who doesn't advocate LSD for anyone because they don't apply to everyone. since I started the subject, I'll answer you.

PIXY's quote:

"If your spouse was over the age of 55 on separation, if you are in a 31%
marginal tax bracket today and expect to stay there, and if you have no need
for the cash in retirement, then you could cash out today to enjoy a
minimum income tax burden on your family over your lifetime.

She has to be at least 59 1/2 this year, and 65 if next year. She can be in the 28% bracket. She can spend the money. She will pay no taxes on this money thereafter. Other facts and sssumption could make this a plus or minus choice. The factors get positive for lesser amounts to LSD, higher individual tax brackets for the retiree and his spouse and his heirs, larger estates, less need to spend the funds after the LSD, longer participation in the plan.

Let me see if I understand some of this.
By taking a lump sum distribution the taxes would be
less than 20% for cap gains.


Forget CG now. I'll get into that later.

The advantage is a smaller tax hit today
versus a longer and higher tax hit in the future - assuming that my MTR
stays at 31%.


Even if it drops to 28%.

I am not sure I understand the comment about not needing cash in
retirement. An example might help me.

Let's say I take a $500,000 lumpsum distribution and
pay the 15% tax or ($75,000).


You'll pay about $128,000 tax on a $500K LSD. That's about a 26% average tax rate.

Doesn't this now make any investment from
the $425,000 my new basis. If I left it and took it on a yearly basis, I'd be
paying 31% in taxes.


Yes, the net $372,000 is all after tax investment money. If you took the $500K out at 31% you'd only have $345,000 to invest (or spend)

Is the concern the loss of the 401K or IRA tax shelter for future returns?

Yes. any tax paid on growth or income from the LSD funds cuts into the above $27,000 tax profit.

First the capital gains:

1. If the plan is an ESOP the LSD is on the difference between the exercise price and FMV. Then you sell the stock a year later and pay normal LTCG (20%) tax on that profit.
2. If you ahve been in the plan over 25 years you get "pre 1974 CG treatment". For instance if you participated for 50 years 1/2 the above $500K gets a flat 20% tax rate ($50,000) and the remainder is only taxed about $50,000 for a total of $100,000 LSD tax, or 20%.

On the original $500K of pension your "Profit" for an LSD is 31% - 26% or 5%. If you funds grew 33% and you had to spend them all, 1/4 of them would be taxed at LTCG rates of 20%, exactly eating up your profit.

However, if you had been in the plan 50 years, your profit is 11%. Your post LSD funds could double and you spend them all and still be slightly ahead.

Looking at the bright side (of the choice not the tax) if you DIDN'T have to spend the funds you'd have $1 mil of pension funds in your estate after they doubled, (assuming you died before age 70 1/2 and hadn't withdrawn anything), and at 26% LSD rates, $740,000 of after taxed LSD funds. At 50%, the FET on the $1 mil would be $500,000 versus only $370,000 on the LSD funds, saving $128,000 (plus the spread of 5% on the $1 mil, or $50,000. The heirs may have to liquidate the IRA (if it had been rolled over, and can't do a LSD on the 401k anymore) FAST at possibly the 39.6% bracket just to pay the FET. So the spread may even be greater. The potential savings to the heirs may be as much as $128K + $50K + another $86K = $264,000 (plus another $26K if it was the 50 year participation).
What was marginal on one assumption can turn into a $1/4 mil inheritance under other circumstances.

Hence, do not make snap judgements as to the inadvisability of an LSD for anyone until you have researched all the possible factors

Is it possible to take a Lump Sum and roll that into
a ROTH which shelters future gains and withdrawal from taxes?
BGP


No you can only roll over an IRA to a Roth and that's at your current tax bracket. If you use an LSD you have to make the post LSD funds LOOK like a Roth by investing in a tax managed index fund and hopefully not have to even spend the growth in it till you get a step-up in basis at death.
I hope this helps you . Ed
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TMF Pixie wrote:
"As of 1/1/87 and through 12/31/96, tax-exempt employers were not allowed to adopt 401k plans. Some (a very few), though, had adopted 401k plans before 1987. Those plans were allowed to continue. Additionally, on 1/1/97 non-governmental tax-exempt employers were again allowed to adopt 401k plans. Evidently your employer is one of those that had a 401k plan in existence before 1/1/87."

Hmmm... we have a state-mandated 401(k) plan for all law enforcement officers. I wonder if a new police department were formed, how would they follow state law?

If the only advantage to taking the money out of 401k is the wider variety, we'll leave it alone. I'm happy both the performance of the options available and plan on leaving it all in an S&P Index fund.

I wasn't sure if there were some tax or dollar issues that made it advantageous to move it to an IRA. Maybe one day she'll resume employment with a government agency (NC state and local government has a 401k through http://nc401k.bbandt.com) and can resume contributions to the original plan.

Thanks!
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Edcosoft sez:

<<Your quote is from PIXY who doesn't advocate LSD for anyone because they don't apply to everyone.>>

NO, that is not what I said. And I suspect you know that full well and are seeking to antagonize me. What I said was "That option, though, requires close examination because it's contingent on a whole host of factors such as your income tax rate today versus that in retirement, your age today, your need for the cash for income, your overall net worth, and a few other things. If your spouse was over the age of 55 on separation, if you are in a 31% marginal tax bracket today and expect to stay there, and if you have no need for the cash in retirement, then you could cash out today to enjoy a minimum income tax burden on your family over your lifetime. However, before you take that step you should consult your tax advisor. For most folks, it simply is not a good option." (emphasis added) I truly resent your trying to put words in my mouth, particularly when they are patently untrue.

For those who are interested, Edcosoft and I have had this exchange before on another board. You may find the thread of that discussion starting at http://boards.fool.com/Message.asp?id=1380039000028023&sort=postdate in message 214 on that board and ending with 225. My rationale for my position is laid out quite clearly therein as is Edcosoft's.

I maintain LSDs may be appropriate in some very limited circumstances. Edcosoft believes otherwise. That's his right. I would just caution folks to look long and hard at this issue before making the choice.

<<She has to be at least 59 1/2 this year, and 65 if next year. >>

That is absolutely correct for the use of 5-year or 10-year averaging. To simply take the lump sum distribution and pay ordinary rates on whatever bracket her $50K would place her, she would need only attain the age of 55 in the year of separation.

Regards..Pixy
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If the only advantage to taking the money out of 401k is the wider variety,
we'll leave it alone. I'm happy both the performance of the options
available and plan on leaving it all in an S&P Index fund.

I wasn't sure if there were some tax or dollar issues that made it
advantageous to move it to an IRA. Maybe one day she'll resume
employment with a government agency (NC state and local government has
a 401k through http://nc401k.bbandt.com) and can resume contributions to
the original plan.

Thanks!


You are obviously not 59 1/2 leaving you with the only options of staying in the 401k or rolling it out into an IRA. There is no advantage in the rollover for you, and it MIGHT be advantageous to have it in a 401k depending on law changes.

Another viable option is to roll it out into an IRA and then convert that into a Roth, possibly part each year to keep from breeching another tax bracket. The IRA to Roth transfer is at your ordinary income tax rates. ed
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"No you can only roll over an IRA to a Roth and that's at your current tax bracket. If you use an LSD you have to make the post LSD funds LOOK like a Roth by investing in a tax managed index fund and hopefully not have to even spend the growth in it till you get a step-up in basis at death.
I hope this helps you . "

Hi Ed,

I do not fall within the 25 nor 50yr 401K time periods. I am glad you spent more time explaining the issues. LSD does not appear to be a viable vehicle for me nor can my mother use it.

I can see where it could be beneficial in some very unique cases.

BGP
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