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New Wrinkle In 401(k)s

January 7, 1993

NEW YORK (AP) _ One of the classic hot potatoes of the investment world got a little hotter with the arrival of 1993.

The items in question are early lump-sum distributions from 401(k) company- sponsored retirement plans - whether prompted by a change of job, layoff, early retirement or any other departure from the payroll.

Under rules that took effect Jan. 1, it can be trickier than ever to handle these distributions without getting scorched.

The new rules mandate a 20 percent withholding tax on any lump-sum payout, unless the money is rolled over directly into another retirement plan, such as a new employer’s 401(k) or a rollover individual retirement account set up by the employee.

Indirect rollovers, in which the employee receives the money and has 60 days to reinvest it, do not escape the withholding tax.

If they proceed with an indirect rollover, employees who have been subjected to this withholding can claim a refund of it at tax-return time. But in the meantime, they have some problems to contend with.

″To protect the full amount of your retirement money from taxes and a possible penalty, you’ll have to fund the entire withheld amount from your other personal assets,″ notes Steve Norwitz at T. Rowe Price Associates in a booklet the investment management firm has published on the subject.

″For people who have contributed regularly to their retirement plan over a long period of time, this shortfall can be a prohibitively large amount of money.″

Buck Consultants, a firm that specializes in pensions and other employee benefits, provides the example of a 53-year-old employee who receives a $100,000 distribution, with $20,000 withheld.

″In order to roll over $100,000, this employee must take $20,000 from another source,″ Buck notes. ″Otherwise, the employee could roll over only the $80,000 actually received.″

In the latter case, the $20,000 not reinvested becomes taxable income. So, in effect, the mere existence of the withholding winds up creating a tax liability.

″On the other hand,″ says Buck, ″the employee who rolls over $100,000 can claim a refund of the full $20,000 withheld, but in the meantime is forced to make an interest-free loan of this amount to the government.

″This can be a loan for up to 18 months, depending on how early in the year the distribution is received.″

As soon as legislation creating the withholding rule was passed last summer, financial advisers came up with a tactic for getting around it.

To receive a distribution without withholding, they suggested, have it rolled over directly into an IRA, and then cash out from the IRA, which is not covered by the withholding rule.

But that strategy has its disadvantages, too. For one thing, an IRA does not permit the use of some ″averaging″ systems that are available with 401(k)s for spreading out taxes on pension distributions over five- or 10-year periods.

Then, too, there is the question of costs that may arise with any rollover. For instance, annual administrative fees that are typically paid by employers in 401(k)s fall to the employee once the money is moved to an IRA.

So in addition to other possible choices, such as direct rollover to a new employer’s 401(k), Stuart Kessler, senior tax partner at the New York accounting firm of Goldstein Golub Kessler & Co., suggests asking whether an old employer will continue your account after you have left.

″Even though most companies discourage you,″ Kessler says, ″it may be to your advantage to keep your money with the company you left, for both tax and investment performance reasons. If your 401(k) investments have done well, why change?″

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