Botching this decision could cost you your retirement savings

Personal finance

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If you’re taking a hefty check from your 401(k) plan as you leave your employer, you might be making a big mistake.

Just over 9 out of 10 employers give their employees multiple options to take a distribution from their retirement plan, according to a new survey from Alight Solutions.

The employee benefits provider polled 240 employers in March.

“As we see more and more boomers retiring – these people who really developed their nest egg in the 401(k) — we see more installment payments and partial distributions offered,” said Rob Austin, head of research at Alight Solutions.

In addition to giving workers a lump sum, close to 80% of employers also allowed a partial distribution and 3 out of 4 companies permitted departing workers to take installment payments from their 401(k).

Choices notwithstanding, 75% of workers opted for a lump-sum distribution.

Here’s what you should consider before making a decision.

Cash out vs. rollover

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Cashing out your 401(k) via a lump-sum distribution carries a hefty cost.

Your recordkeeper will withhold 20% of the check to cover income taxes. If you’re under age 59½ when you get the money, you’re also subject to a 10% penalty.

Another option for employees who are on the way out: Keep your 401(k) where it is or roll your savings into another 401(k) that will accept it. If you’re nearing retirement, you can work with your financial advisor to find a retirement drawdown strategy that is right for you.

Finally, departing employees can also opt to roll the money into an individual retirement account.

Just be aware that the IRA comes with its own share of trade-offs.

For starters, IRAs generally give investors a broader array of investments compared to what’s available in the 401(k).

The average large 401(k) plan in 2016 offered 27 investment options, according to the Investment Company Institute and BrightScope.

Investing expenses also differ between 401(k) plans and IRAs.

Fund fees for domestic stock mutual funds in a 401(k) averaged around 0.45%, while domestic bond funds cost 0.35%, according to BrightScope and the ICI.

Small 401(k) plans — particularly those with less than $10 million in assets — are more costly. These fees can be as high as 1.19% to 1.95%, according to a study from America’s Best 401k.

Meanwhile, advisors can charge approximately 1% to manage your rollover assets in an IRA.

Finally, money held in a 401(k) plan is protected by the Employee Retirement Income Security Act (ERISA).

This federal law requires individuals who manage the plan to act as fiduciaries and operate in the best interest of the participants.

Further, ERISA protects your 401(k) plan savings from seizure by creditors.

You don’t have these same protections in IRAs.

A series of payments

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Check your workplace retirement plan to determine what options are available to you.

Generally, there are four choices.

You can leave your money in the plan, take payments from it in installments, roll the money to an IRA or take a lump sum.

Work with your financial advisor before you decide on how to proceed, as the answer that’s right for you will depend on your taxes, time horizon and other income sources you hold.

“If you take the lump sum as cash, it’s fully taxable,” said Austin. “But if you take installment payments or a partial distribution, that amount could also be taxable.

“You’ll want to plan it accordingly and not be in a high tax bracket the year you take the distribution,” he said.

Don’t forget: Whether you put the money in an IRA or keep it in the plan, you’re going to be expected to take required minimum distributions when you hit 70½.

Getting educated

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Here are a few considerations before you decide how to proceed.

Understand your expenses. You must budget and stretch your savings. Figure out what you’ll need each month and see how it squares against your retirement income sources, including Social Security.

Build in an emergency cash cushion so that you aren’t taking high interest loans in an emergency.

Don’t forget taxes. How you choose to draw down your 401(k) plan will have an impact on your tax bill. Lump sum cash outs are likely to result in a hefty tax bill that year, versus spreading out your distributions over time.

Get familiar with your choices. Employers could do a better job of educating their workers on the distribution options available within the plan, Austin said.

In the meantime, coordinate with your advisor to evaluate your income sources and tax brackets to figure out the best way to tap your savings in retirement.

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