7 Problems with your 401(k)
You'd be shocked at how many 401k's we've looked at where the plans don't make sense! Whether they charge to high in fees, offer limited investment portfolios, or their withdrawal and rollover provisions are off. No 401(k) plan is perfect, and it's the same thing for any other qualified employer sponsored plan. They're just offering it to be competitive and it's one of the few ways people can save in America. I'm certain it's better than nothing, but maybe understanding the pitfalls in your 401k will give you motivation to pursue other means of saving for your retirement and building generational wealth.
So here's another excerpt from my dad's book, "Bat Socks, Vegas and Conservative Investing." I hope you don't mind his quippy humor for financial writing. But if you dig in, I know you'll get many great insights.
Problem #1: Is Your 401k Compliant?
Is your employer or former employer’s 401k plan compliant? Will it stay compliant when you are retired? You would think this is an “automatic yes”, but apparently not. The IRS on its website has some enlightening information as it relates to plans that go bad.
It appears that beginning in 2002 the IRS started to examine Form 5500 returns for 401(k) plans in various geographical areas throughout the country. They analyzed these returns and identified issues in detail.
“The issues identified in the examination of 401(k) plans within the various market segments mirrored those identified in 401(k) plans as a whole. The cause of these errors varied from case-to-case. However, the overwhelming identified cause of an error occurring in 401(k) plans within the completed market segments was the Failure to Follow the Terms of the Plan.” (3)
The rather astounding discovery of the IRS analysis was that the employer failed to follow the rules of its own plan documents. The IRS even lists the top ten reasons for plan failure right on their website. (4) Of course we all know that trying to follow the IRS and its details is akin to nailing Jell-O to a wall, but these are professionals who make the mistakes, not amateurs.
While I am confident all the details of your 401(k) plan are given the attention they deserve, there is still the outside possibility they aren’t or the IRS Website would not be listing the top reasons for plan failures. The question is how do you know your company is following the rules? Do you simply trust your company as most do? It would seem important for a successful retirement that your assets reside in a secure environment where they are free from the kind of exposure listed on the IRS Website. The reason is simple: failure of a 401(k) plan triggers total taxation of Plan benefits for everyone in the plan!
Granted, this doesn’t happen often because the IRS will allow the sponsoring company a certain amount of leeway to make corrections. Yet, I can’t help thinking of all the broken pension promises over the years from highly reputable companies who cut benefits for retirees because they messed up the pension fund. It’s just a thought. Maybe pulling money out of your 401(k) before somebody at the home office screws up the accounting might make sense.
Otherwise, you might be saying, “I should have listened”.
Problem #2: Roth accounts in a 401(k) have issues.
A Roth opened inside a 401(k) account is referred to as a DRAC, a Designated Retirement Account, and has to follow a different set of rules than a normal Roth IRA.
Typically Roth IRA’s provide an excellent vehicle for those saving for retirement and those already retired who want tax advantaged income. There can be no better tax advantage than tax-free income and that’s what a Roth IRA provides. Monies deposited in a Roth IRA are tax-free once the account has passed it’s “nonexclusion” period of 5 years. Money can be withdrawn prior to the five years on a FIFO (First In, Firs Out) basis, which simply means your principal is taken out first. Yet after the 5 year period all monies withdrawn are tax free.(5)
The IRS also considers the Roth beginning date for any Roth contributions as January 1st of the year in which the account was opened. For example, if you opened a Roth on November 11th of 2010, the start date of the “nonexclusion” period would be January 1st of 2010. The client could then start taking tax-free withdrawals from the account January 1st, 2015. Opening a contributory Roth account begins the 5 year “nonexclusion” period for all ensuing Roth accounts, unless they’re in a 401(k). If a Roth is a DRAC then each new Roth opened inside other 401(k) plans with subsequent employers start a new 5-year period before tax-free money can be withdrawn.(6)
A Roth account inside a 401(k) plan is also subject to the same rules as the 401(k) plan. There is one rule that is especially troublesome for a Roth inside a 401(k). A Roth inside a 401(k) is subject to the Required Minimum Distribution rules. In other words, you would be required to start taking income out of your Roth at age 70 and a half just like a regular IRA.(7) This is not true with a Roth outside a 401(k) plan.
The lifetime RMD rules can only be prevented by rolling the DRAC to a Roth IRA outside the 401(k) plan.
The DRAC 5-year nonexclusion period does not carry over to the new Roth IRA. Opening a Roth account, outside a DRAC will begin the 5 year “nonexclusion” period for all ensuing contributory Roth accounts opened at later dates, as Natalie Choate says in her book, “Life and Death Planning for Retirement Benefits”:
“The Five-Year Period (called in the statute the “nonexclusion period”) for all of a participat’s Roth IRAs begins on January 1 of the first year for which a contribution was made to any Roth IRA maintained for that participant.”(8)
In other words, if a client opened a Roth on November 11th, 2010, the beginning date for figuring in the 5-year nonexclusion period for all other Roth accounts started after 2010 would then become January 1st, 2010. (9)
I suggest you start a new Roth to begin a five year “nonexclusion” period for future rollovers of DRAC’s.
Problem #3: Limited choices.
Surely one of the greatest problems with 401(k) plans are the limited investment choices, especially when it comes to conservative investing. While larger company plans offer a variety of mutual fund companies and a few money markets they pale in comparison to the universe of options available outside a 401(k). Smaller companies have even fewer choices, some with only one family of funds.
This is a conservative investor’s nightmare when it comes to finding an asset that doesn’t experience market losses. Remember Warren Buffet’s first rule of investing? Don’t lose any money! Rule number two? Never forget rule number one. When you look at your 401(k) plan with absolutely no options for protected assets and this is your primary retirement account it’s enough to start you looking for the barf bag in the back of the seat in front of you. No kidding!
If having no protected accounts wasn’t bad enough, all you have to help you decide where to invest is a little booklet explaining the options. It lists the fund families, shows the returns of all the mutual funds, and explains the rules. You look around for help and the Human Resource personnel are nice people, but they are not financial advisors. The broker may come to the offices once a year. Some companies are located in a different city than the broker who set up the plan and employees have no access to him.
Of course, the final insult is the limited ability to make changes within your plan. To do so you either have to go on line, run through the website maze, or call a toll free number and fumble through the companies phone options. If by chance you finally land on the right option, you end up misplacing your PIN number and have to start all over again!
This is not good. This is not choice. This is a conservative investor’s highway to insanity, much like a 14 week remodel job. (Did I mention I should have listened!?)
Problem #4: The 20% Withholding Trap.
Well now, we’re making progress. You finally decide you want to get out of your 401(k) plan only to find out your company withheld 20% of your account which you will have to pay the taxes on next year’s return. Say what?
First you have to understand what a “distributive rollover” is. You have probably heard you can receive money from a pre-tax dollar plan, put the money in your account and have 60 days to find a new plan and deposit the assets. That is called a distributive rollover because they distributed the money to you. However, with 401(k) plans the IRS rules require the Plan to withhold (for federal tax) 20%. NO EXCEPTIONS! Since you don’t receive the 20% it is taxed at the end of the year as a distribution. Not only that but you can only rollover once every 12 months.
So, here’s the No Tax Distribution plan or how to avoid the 20% trap. Don’t have the company make the check out to you, but rather have the Plan make the check out to the company you want to invest with. Make use of what’s called a “Trustee-to-Trustee Transfer”. You never see the check, it is sent directly to the next company. No withholding.
In some instances a Plan will make the check out to the new company, but send it to you. Don’t worry, this won’t trigger any withholding. Simply forward the check on to the company you want to invest with.
The 20% Withholding Trap is easily avoided if you follow the rules. Using a professional is often helpful in these matters. (Make sure he’s a financial professional and not a contractor.)
Problem #5: Limited Beneficiary Options.
Don’t take this wrong, but if your spouse is the only option listed on your 401(k), it’s a bad thing. This is one of the more distressing items on the list. Most people would like the money in their Plan to go to their spouse, but what happens if you and your spouse die in a tragic remodeling accident (It could happen)? Where does the money go? I’m sure the state you live in has planned for this, but I’m pretty confident you would not want the state to control this decision. The problem is many Plans only have one place for a beneficiary or the participant never filled out a beneficiary form.
To solve this problem check your beneficiary designations on your Plan to make sure you have listed at least one person to receive your money other than the state of course. You would be surprised at how many people have missed this step completely and die with no beneficiaries listed.
I would suggest you conduct a beneficiary review with a financial professional or legal counsel. They can run through your beneficiary options with you. It’s important to not only list a primary beneficiary, but also “contingent” and “tertiary” beneficiaries. A primary beneficiary receives all the Plan assets when you pass away. If you and your primary beneficiary pass away together in a car accident (sorry), your listed “contingent” beneficiary would inherit Plan assets. Generally, you list your spouse as a primary beneficiary, followed by your children. You might have one primary and three contingent beneficiaries. The most common way to list contingent beneficiaries are by percentages. Just remember that the percentages have to add up to 100%.
You can also list “tertiary” beneficiaries, which are people who receive Plan assets if you and your contingent beneficiaries die in a plane crash on your way to a family vacation, (again, sorry). That would mean you and your immediate family was most likely taken out of the inheritance picture. Then, you might want to list grandchildren, nieces, nephews, brothers, sisters, or parents.
Tertiary beneficiaries can be used in many ways to pass on assets in complex estate plans to help with taxation. If you don’t think of it ahead of time, your children won’t have helpful options come tax time. For instance, if one of your children wanted to “disclaim” their share of the inheritance and let their kids, your grandchildren, inherit the Plan assets so they could avoid a heavy tax, you would have to plan out the option in advance.
Think of it this way. Primary beneficiaries are first level inheritors; Contingent beneficiaries are second level inheritors; and Tertiary beneficiaries are third level inheritors.
You can see that a “beneficiary review” of your Plan might be in order. One of the details you may discover about your 401(k) plan is that it doesn’t provide for the any of the above listed options. That would simply be another reason to rollover your plan into an IRA where you can have exactly what you want to happen upon your demise a certainty.
You don’t want to end up at death saying, “I should have listened”. Well, that’s a stretch, but you get the idea.
Problem #6: Required Minimum Distribution Errors.
Let me ask you a question. Say, you are retired and have an IRA worth $250,000, a 401(k) worth $100,000, and a 403(b) worth $125,000, are 71 years old and are planning to take your Required Minimum Distribution. Can you withdraw an amount from just your 401(k) plan sufficient to cover all three plans? Many people along with many advisors make the same mistake of saying “yes”. That’s correct. “Yes” is a wrong answer. You must take a Required Minimum Distribution from each type of plan. A 401(k) RMD cannot cover other qualified plan RMD requirements. This may well be the most common mistake made amongst plan holders.
Yet, if you were to hold three separate IRA’s you could take one Required Minimum Distribution from just one of the accounts sufficient to cover all three accounts. This would allow you to take a distribution from an underperforming asset leaving more money in better performing assets. Imagine that kind of flexibility and you can imagine yourself out of your 401(k) plan, and into stronger options.
Are you listening?
Problem #7: 401(k)’s are the Non-Stretch Plan.
This could cost your heirs a million. A Stretch or Multi-Generational IRA plan is a plan in which your assets are passed to beneficiaries who leave them in the plan and simply take Required Minimum Distributions based on their IRS life expectancy tables. This allows the assets to grow tax-deferred over generations. Many 401(k) plans don’t allow for this advantageous strategy.