Defined Contribution Plans
Managing Your Retirement
There's a pretty good chance that if you've been gainfully employed for any period of time and are close to retirement age, you have something called a "defined contribution plan." Defined contribution plans travel under many confusing aliases, including money purchase plans, profit sharing plans, and employee stock ownership plans (see the discussion in our Foolish Retirement Plan Primer for details). Adding to the confusion, one or more of these types of plans are often combined. For most Fools, though, a defined contribution plan is most likely to be simply known as a 401(k).
For the purposes of what follows, and to keep things simple, let's assume that you're retiring (Woo-hoo!), have a 401(k) plan that you've been contributing to (Woo-hoo! Woo-hoo!), and that your employer hasn't explained much about the methods of taking your money with you when you leave (yikes!). This, actually, is a pretty common scenario for the average Fool.
Upon retirement, your defined contribution plan will typically permit you to take a lump-sum payment. In many plans, after you have reached normal retirement age (as defined by the plan), a lump-sum payment will be the only choice you have. You just have to take the whole chunk of cash with you when you leave.
Many other plans, though, will allow you to take annual installments paid typically over a period of not less than 2 nor more than 15 years. A few plans will even allow you to convert your plan proceeds to an annuity payable over your life or the joint lives of you and your spouse. (See Selecting a Company Pension Payment Plan for more details.)
While having a choice between a lump sum, annual installments, or annuity payouts is nice, be aware that it is a one-time irrevocable decision with significant tax consequences. It behooves you, therefore, to devote a little more time to understanding your options than the amount of time you spend planning your blowout party on your final day at the office. Actually, if you spend time figuring out your choices, you may save enough money over the long term to justify making your good-bye extravaganza that much bigger.
The Lump-Sum Payment
If your defined contribution plan allows you to choose a lump-sum payment, you have these choices:
- You may take all the money immediately -- and pay ordinary income taxes immediately.
- You may transfer the money directly to an Individual Retirement Account (IRA) to continue the tax deferral until you begin withdrawals. (Warning! The note that follows may confuse you if you don't read it twice: Any after-tax employee contributions you made to a 401(k) or other defined contribution plan are not taxable and may not be transferred to an IRA. Such monies will normally be provided to you in a separate check, which you may cash and use as desired.)
- You may take part of the benefit immediately (paying income taxes on that part) and transfer the rest to an IRA.
Usually, the best choice for a lump-sum distribution is to simply transfer your money to an Individual Retirement Account. For more information on how to do so, click onto our article Getting the Loot to an IRA.
By transferring your 401(k) money to an IRA, the tax-deferred status of that sum continues and your current tax burden is kept to a minimum. However, we'll now repeat these Foolish words of wisdom from our article on Selecting a Company Pension Payment Plan in case you're one of the few people out there who hasn't read it yet:
"You must look at your entire financial situation to evaluate the tax impact of keeping the money and paying taxes today versus deferring those taxes to future years through withdrawals from an IRA. This is a topic that requires discussion with your tax advisor, who is in the best position to analyze the alternatives based on your tax situation. That analysis may cost you a few hundred dollars, but it could also save you far more in income and/or estate taxes. Consider the fees paid to the tax advisor money well spent because they may very well save you from a costly error."
We Fools are, for the most part, do-it-yourselfers. However, for a choice as important as how to take the rest of your life's income, we're pretty sure that this 1,000-word article isn't going to provide all the answers. We think you'd be well-advised to sit down with a tax advisor who can go over your individual financial situation. While we'd love to be able to give short, quippy answers to all of life's financial questions right here, we realize our limits in this regard. Please swing by our Retirement Investing message board with any questions you have, though, so that you can make a meeting with a tax advisor shorter and smoother.
If you have and use the option to take your defined contribution money in the form of an annuity, all payments will be taxed as ordinary income when received. Those payments are ineligible for transfer to an IRA.
The Installment Payment
A final option is the installment payment, which works differently from the annuity or the lump sum. With this option, you will receive the market value of a certain number of shares (sometimes called units) you hold in your investment accounts each year.
For example, let's say you opt to take five installments from your 401(k) plan. On the day you retire, you will receive a check for the market value of one-fifth of the shares you hold on that day. You now have four installments remaining to be paid.
One year later, you will receive a check for the market value of one-fourth of the shares remaining in your plan accounts. The size of the checks you receive is solely contingent on the share value of your investment accounts on the day the payments are made. You may or may not be able to change your investment accounts during the installment payment period. That's up to the plan.
Income tax treatment of these payments will depend on the period of time over which you choose to receive installments. If the payments will last 10 years or more, then each one will be taxed at ordinary income rates in the year received. However, installments paid over a period of less than 10 years may be transferred to an IRA to continue the tax deferral. For more information on getting your money to an IRA, read the Getting the Loot to an IRA article.
And there you have the scoop on defined contribution plans. Now it's time for Taking Stock.