Maximizing a Stretch IRA

Conventional wisdom says that when you leave a job, whether you’ve been “downsized” or you’ve just decided to take the leap, you should always move your retirement plan to a self-directed IRA. (Note: when referring to “retirement plans” in this article, this could be a 401(k) plan, a 403(b), a 457, or any other qualified savings deferral-type plan).

But there are a few instances when it makes sense to leave the money in the former employer’s plan.

You have several options of what to do with the money in your former employer’s plan, such as leaving it, rolling it over into a new employer’s plan, rolling it over to an IRA, or just taking the cash.

The last option is the worst. You’ll automatically lose 10% via penalty from the IRS (unless you meet one of the exceptions, including first home purchase, healthcare costs, and a few others) if you’re under age 59 1/2, plus you’re taxed on the funds as if it were income. For the highest bracket, this can amount to losing as much as 45% of the account.

In addition, if you think about it, by cashing out you’re derailing the retirement fund that you’ve put so much effort into setting aside. If you cash it out, you’ve got to start over, and you’ve got less time to build the account back up. A 2005 change in the tax law requires your old employer to automatically roll over your account into an IRA if it is between $1,000 and $5,000 (if you don’t choose another option), to keep folks from cashing out. If your account balance is more than $5,000, the old employer is required to maintain your account in the old plan until you choose what you’re going to do with it.

With recent tax law changes, another option has become available for your old account: you can now roll these funds over into a new employer’s retirement plan, as long as the plan allows it. In many cases this may make good sense, especially if the new plan has good investment choices and is cost-effective.

If the new plan doesn’t suit you, you can always roll the funds from your old employer’s plan into an IRA. You’ll then be able to decide just how you want to allocate the investmtents, choosing from the entire universe of available investment options, rather than the limited list that many plans have available. Caution is necessary when doing this type of rollover, as a misstep could cause the IRS to treat your attempted rollover as a complete distribution, having the same tax effect as cashing out. Seek the help of a professional if you are unsure about how to deal with this situation.

But when would you leave the funds at the old employer? If the old employer’s plan is a well-managed, low-cost plan, and you’re happy with how your investments have done, then you might just want to leave it where it is. In addition, if you happen to be over age 55, you may have options available to access the funds immediately, rather than waiting until age 59 1/2 – but only if you leave the funds in the original employer’s plan. Plus, if your plan is a 457 plan (generally only available to governmental employees, such as the State), you may be able to tap the plan upon your ending employment without penalty as well.

Another good reason to leave the fund at the old employer is if you believe that there is a high probability that you may return to employment with this employer. Especially in the case of working for the State, it probably makes sense to leave those funds in the SERS plan when you think there is a better than average possibility that you may return to work with the State (even another agency), as there are benefits available in the plan that you would be giving up if you moved your account to an IRA, and you’re not likely to be able to move those funds back when you return.

So – hopefully this quick conversation has helped to clear up some questions, and perhaps it has brought up some new questions for you. Don’t hesitate to contact me if you’re unclear about the choices that you have available. I’ll be happy to discuss it with you.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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