Saving for retirement is one of those aspects that too many U.S. workers overlook. No matter how much one earns in a monthly or annual salary, none of that matters once retirement age is reached. On average, workers save far less for retirement than financial experts recommend, and this can lead to an unstable financial future.
One of the many retirement strategies available to those planning for retirement is the Individual Retirement Account, or IRA. There are several types of IRA, including tax-deferred plans, each with their own benefits and drawbacks. These can be used to supplement or to replace other retirement plans, such as employer-sponsored pensions and government-backed Social Security benefits. In this series of articles, we’ll discuss what you need to know about IRAs and what strategies are available in protecting these valuable retirement assets, such as rolling over IRAs when you change employers.
Earning Power Defined
Before discussing IRAs and rollover options, it is important to understand the concept of “earning power”. Simply put, this is a person’s ability to earn an income over his or her working career. Your earning power is the most important financial asset you have, providing the income needed to pay for current expenses as well as to set funds aside for future needs. Without an income, how will you pay your bills? How will you and your family survive once you stop working at retirement? These are important questions to answer as you plan for the future.
For the purposes of this discussion, let’s look at a couple examples of earning power. Take, for example, a 30-year old couple that earns a combined income of $100,000 each year until they reach retirement age at 65. Ignoring work bonuses, raises, and other sources of income such as investments, this couple will earn over $3.5 million during the course of their careers. Bump the annual combined income to $250,000, and that same couple will earn close to $10 million by the time they reach retirement age. Again, it is critical to understand that no matter how much you make now, if you haven’t saved money aside for retirement needs, you may be facing an uncertain financial future.
The best-laid retirement plans can be derailed when one changes jobs. For employees who have employer-sponsored plans like IRAs and 401(k) plans, changing jobs means making tough decisions about what to do with the money you’ve accumulated in your retirement account. Since these are funds set aside for retirement purposes, what you do with them now may positively or negatively impact your financial future. Let’s take a look at some of the options available for handling your retirement assets:
In most plans, when you change jobs you are eligible to withdraw the money you’ve accumulated in one lump sum. This sounds like an easy solution, but it is rarely a good idea to do this, unless you have an unforeseen emergency and need the funds right away. Why is withdrawing early a bad idea? Consider these aspects:
- Federal tax law requires that a mandatory 20% tax withholding will be subtracted from the lump sum you receive from your previous employer.
- There may also be additional state and federal tax withholdings on the distribution of lump sum funds. This distribution, because it is considered taxable income, may push you into a higher tax bracket with associated tax implications.
- While there are exceptions to tax penalties for withdrawing funds early, you may likely have to pay a 10% premature distribution tax in addition to the regular income tax withholdings.
- Despite the potential tax penalties and payments, if you withdraw the money now, you cannot take advantage of the continued tax-deferred growth of the assets in the retirement plan.
Leaving the Funds in Place
Even though you are leaving or have left your current employer and taken a new job elsewhere, it is possible to leave your retirement fund in place with the old employer. The funds will continue to grow on a tax-deferred basis. This can be a smart option, particularly if you have had a good track record with the fund’s growth performance. Even leaving them temporarily while you research other options makes smart financial sense, and avoids tax penalties while you decide what to do with the assets. Remember, though, that for those employees with less than $5000 in vested balance may be required to take a lump-sum distribution, even if better options exist.
Perhaps the best option for those of us who have a retirement plan with a previous employer and now find ourselves in a new job is to roll over the funds. What does this mean? Simply put, it means taking the funds accrued in your previous employer’s retirement plan and placing them in the new employer’s plan, or to establish an IRA with the funds. The IRA can be a traditional or Roth IRA, giving you better control over your retirement assets. Not all employer-sponsored plans offer the possibility of a rollover, so it is important to check specifics before attempting to use this option. Rolling over funds into a new retirement plan avoids tax penalties and allows the funds to continue growing in a tax-deferred environment.
Next Up: Exploring Options
In this article, we’ve discussed some of the options available to protect retirement assets when transitioning to a new employer. We’ve talked about some of the drawbacks and benefits to these options, giving you a better idea of what steps you can take to preserve a stable financial future. In our next blog post, we’ll dig even deeper into these options with a particular focus on rollovers and how they represent the best possible solution. Stay tuned for more.