Take the money and run — lump-sum distributions

When you retire, you can generally withdraw your 401(k) funds in a lump-sum cash payment. To do this, simply instruct your plan administrator to cut you a check. Then, you're free to do whatever you please with those funds. You can use them to meet expenses (e.g., medical bills), put them toward a large purchase (e.g., a home or car), or invest them elsewhere.

While cashing out is certainly tempting, it's almost never a good retirement strategy. Taking a cash distribution can significantly reduce your retirement savings, and is generally not advisable unless you urgently need money and have no other alternatives. Not only will you miss out on the continued tax deferral of your 401(k) funds, but you'll also face an immediate tax bite.

First, you'll have to pay federal (and possibly state) income tax (at ordinary income tax rates) on the money you withdraw, except for the amount of any after-tax contributions you've made (special rules apply to Roth contributions, discussed below). If the amount is large enough, you could even be pushed into a higher tax bracket for the year. If you're under age 59½ when you retire, you'll also have to pay a 10% premature distribution penalty tax on the taxable portion of your distribution, unless you qualify for an exception. And, because your employer is required to withhold 20% of your distribution for federal taxes, the amount of cash you get may be significantly less than you expect.

• The payment is made after you turn age 59½, become disabled, or die, and
• The payment is made after the five-year period that starts with the year you make your first Roth contribution to the 401(k) plan.

Leave the funds in your employer's plan

Another option when you retire is simply to leave the funds in your employer's 401(k) plan where they will continue to grow tax deferred. Leaving your money in your 401(k) plan may be a good idea if you're happy with the investment alternatives or distribution options offered, or you need time to explore other options.

However, you may not always have this opportunity. If your vested balance is $5,000 or less, your employer can require you to take your money out of the plan when you leave the company; however, if the account is more than $1,000 the employer will have to roll the money into an IRA in your name. (Your vested balance consists of anything you've contributed to the plan, as well as any employer contributions you have the right to receive.) Also, your employer isn't required to let you keep your funds in the plan after you reach the plan's normal retirement age (usually age 65).

If you decide to leave your funds in your employer's 401(k) plan, you may have the option of converting all or part of your non-Roth accounts to a Roth account. You'll pay federal income tax at the time of the conversion, but qualified distributions will be income tax free. Check with your plan administrator to see if this option is available to you.

If you are able to leave your funds in your employer's plan, at some point you'll need to select a distribution option. As noted earlier, the options available to you depend on the specific terms of your employer's 401(k) plan. Your plan will also specify when you must begin taking distributions. Typically, some or all of the following distribution options will be available to you:

• Fixed period of time: You receive installment payments over a fixed period such as 10 or 15 years. The period of time cannot be longer than your life expectancy, or the joint and survivor life expectancy of you and your beneficiary. Payments are set in an amount calculated to deplete the account balance by the end of the specified period. Payments will typically be adjusted upward or downward if actual investment returns are different than anticipated.
• Based on a life expectancy calculation: You receive installment payments based on a specified life expectancy calculation such as a single life expectancy. The applicable life expectancy figure is determined by referring to IRS tables. This option is similar to the fixed period of time option, but the payout period used is not a specified number of years; it is based on the applicable life expectancy instead.
• Fixed amount until balance is exhausted: You receive regular payments in a fixed amount that is paid periodically until there are no funds left in the account. Some assumptions as to future investment returns is necessary to estimate the length of the payment period. The actual period may vary depending on investment results, but the amount of each payment never varies.
• Annuity: An increasing number of 401(k) plans are starting to provide annuities as a distribution option. An annuity generally provides guaranteed payments for your life (or sometimes over the joint lives of you and your spouse or other contingent annuitant). An annuity might be a good option for you if you're concerned about your ability to direct the investment of your funds yourself. An annuity also provides a fixed income that you won't outlive. However, like other fixed income investments, your benefit can be eroded by inflation. Also, an annuity is generally a poor choice for those in bad health — you run the risk of premature death, in which case your payments generally end, leaving nothing to your heirs. If you like the idea of annuitizing all or part of your 401(k) plan funds, you might get a better deal by doing so inside your 401(k) plan than you would on your own, as plans are generally eligible for lower institutional pricing.

Roll the funds over to an IRA

When you retire, you can roll over all or part of your non-Roth 401(k) funds into a traditional IRA. You can transfer the funds either to a traditional IRA that you already have, or open a new IRA to receive the funds. A rollover can be direct (your plan's trustee sends the funds directly to your IRA, or issues a check to you payable to your IRA) or indirect (your plan's trustee pays the funds to you, and then you deposit the funds into your IRA within 60 days).

An indirect rollover is generally a bad idea if you want to roll over your entire distribution. This is because, with an indirect rollover, your plan administrator will be required to withhold 20% of your taxable distribution. This means that you'll need to have additional funds available to replace the 20% withheld at the time of distribution. (You'll get credit for the 20% withheld when you file your federal income tax return the following year.)

If you do not make up the 20% with additional funds, the 20% withheld will actually be considered a taxable distribution. If you fail to complete the rollover within 60 days, the entire distribution may be treated as a taxable distribution.

A properly completed rollover (direct or indirect) is a tax-free transfer of assets, not a taxable distribution. This means that you will not be subject to income tax or early withdrawal penalties on the money. You won't pay federal or state income tax on the money until you begin taking taxable distributions from the IRA. By that time, you may be retired and in a lower income tax bracket. Also, if you are 59½ or older when you take distributions from your IRA, you won't have to worry about premature distribution penalties.

When you roll over funds from your 401(k) plan to your IRA, you are simply moving your retirement money from one tax-favored savings vehicle to another. This allows the money to continue growing tax deferred in the IRA with little or no interruption. There's no dollar limit on how much 401(k) money you can roll over to an IRA.

You can also roll over a distribution of your non-Roth 401(k) money to a Roth IRA. These rollovers are often called "conversions," because they are similar to a conversion of a traditional IRA to a Roth IRA. The taxable portion of your distribution from the 401(k) plan will be included in your income at the time of the rollover.

If you've made Roth contributions to your 401(k) plan, you can roll those contributions, and any investment earnings on them, to a Roth IRA only. Qualified distributions from your Roth IRA will be free from federal income taxes.

Your Roth 401(k) five-year holding period does not carry over to your Roth IRA. You must separately satisfy the five-year holding period for Roth IRAs. The five-year holding period generally begins on January 1 of the tax year in which you made your first contribution (regular or rollover) to any Roth IRA.

Some distributions cannot be rolled over, including required minimum distributions and certain annuity and installment payments.

Advantages of rolling your funds over to an IRA:

• You generally have more investment choices with an IRA than with an employer's 401(k) plan. You typically may move your money around to the various investments offered by your IRA trustee, and you may divide up your balance among as many of those investments as you want. By contrast, employer-sponsored plans typically give you a limited menu of investments (usually mutual funds) from which to choose.

Disadvantages of rolling your funds over to an IRA:

• If you roll over all or part of your 401(k) distribution into an IRA, neither that distribution, nor any future lump-sum distribution you receive from the 401(k) plan, will be eligible for special 10-year averaging or capital gains treatment (see below).
• Distributions from your 401(k) plan won't be subject to the 10% premature distribution penalty if you retire during the year you turn 55 or later. However, distributions from your IRA before you turn age 59½ will be subject to the penalty tax, unless an exception applies.
• Assets in employer plans that are subject to the non-alienation provisions of ERISA [for example, most 401(k) plans] receive virtually unlimited protection from creditors under federal law. Your creditors cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you've declared bankruptcy. In contrast, traditional and Roth IRAs are generally protected under federal law only if you declare bankruptcy. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you are concerned about asset protection, be sure to seek the assistance of a qualified professional.
• Many employer-sponsored plans have loan provisions. You cannot borrow from an IRA — you can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties.
• While IRAs typically provide more investment choices than an employer plan, there may be certain investment opportunities in your particular plan that you cannot replicate with an IRA. Further, you may be satisfied by the low-cost institutional funds available in your particular plan, and therefore you may not regard an IRA's broader array of investments as an important factor.
• You may be able to postpone required minimum distributions by leaving funds in an employer retirement plan. These distributions usually must begin by April 1 following the year you reach age 72 (70½ if reached before 2020). However, if you work past that age and are still participating in your employer's plan, you can delay your first distribution from that plan until April 1 following the year of your retirement. (You also must own no more than 5% of the company.) This deferral exception is not available for IRAs. (Minimum distributions are not required from Roth IRAs during your lifetime.)
• You'll be responsible for investing your lump-sum dollars until you need them. Investment losses, especially in your early years of retirement, could also cause you to experience a retirement income shortfall.

• Both employer retirement plans and IRAs typically involve: (1) investment-related expenses, and (2) plan or account fees. Investment-related expenses may include sales loads, commissions, the expenses of any mutual funds in which assets are invested, and investment advisory fees. Plan fees typically include plan administrative fees (e.g., recordkeeping, compliance, trustee fees) and fees for services such as access to a customer service representative. In some cases, employers pay for some or all of the plan's administrative expenses. An IRA's account fees may include, for example, administrative, account set-up, and custodial fees. Be sure to carefully consider the expenses and fees in each alternative.
• Also be sure to consider the different levels of service available under the employer's plan versus an IRA. Some employer plans, for example, provide access to investment advice, planning tools, telephone help lines, educational materials, and workshops. Similarly, IRA providers offer different levels of service, which may include full brokerage service, investment advice, distribution planning, and access to securities execution online.

Net unrealized appreciation

When you receive a lump-sum distribution from your employer's retirement plan, the distribution is generally taxable to you at ordinary income tax rates. As discussed above, a common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they'll also be taxed at ordinary income tax rates. (Special rules apply to Roth and other after-tax contributions that are generally tax free when distributed.)

But if your distribution includes employer stock (or other employer securities), you may have another option — you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won't be taxed on NUA until you sell the stock. What's more, NUA will be taxed at long-term capital gains rates — typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.

If you want to take advantage of NUA tax treatment, be sure you don't roll the stock over to an IRA. That will be irrevocable, and you'll forever lose the NUA opportunity.

A distribution of employer stock consists of two parts: (1) the cost basis (i.e., the value of the stock when it was contributed to, or purchased by, your plan), and (2) any increase in value over the cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA. For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.

At the time you receive a lump-sum distribution that includes employer stock, you'll pay ordinary income tax only on the cost basis in the employer securities. You won't pay any tax on NUA until you sell the securities. At that time, NUA is taxed at long-term capital gain rates, no matter how long you've held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of NUA is taxed as either short-term or long-term capital gain, depending on how long you've held the stock outside the plan.

Using the example above, you would pay ordinary income tax on $50,000 (the cost basis), when you receive your distribution. (You may also be subject to a 10% early distribution penalty if you're not age 55 or totally disabled.) Let's say you sell the stock after ten years, when it's worth $750,000. At that time, you'll pay long-term capital gains tax on NUA ($450,000). You'll also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. Since you've already paid tax on the $50,000 cost basis, you won't pay tax on that amount again when you sell the stock.

If your distribution includes cash in addition to the stock, you can either roll the cash over to an IRA or take it as a taxable distribution. And, you don't have to use the NUA strategy for all of your employer stock — you can roll a portion over to an IRA and apply NUA tax treatment to the rest.

If you die while you still hold employer securities in your retirement plan, your plan beneficiary can also use the NUA tax strategy if he or she receives a lump-sum distribution from the plan. The taxation is generally the same as if you had received the distribution. (The stock doesn't receive a step up in basis, even though your beneficiary receives it as a result of your death.)

In general, the NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it's right for you depends on many variables, including your age, your estate planning goals, anticipated tax rates, and your state's tax laws. Also keep in mind that stock held in an IRA or employer plan is entitled to significant protection from your creditors. You'll lose that protection if you hold the stock in a taxable brokerage account.

10-year income tax averaging and special capital gains treatment

If you were born before 1936, there are two other special tax rules that may apply to your lump-sum distribution: 10-year income averaging and special capital gains treatment. For more information refer to IRS Publication 575. Be sure to consult a tax