Employer Retirement Plans: Contributions, Distributions, and Vesting

When you begin to participate in your employer’s retirement savings plan, you’ll have some choices to make. If you’ve been automatically enrolled, you’ll have to decide whether to stick with the contribution and investment defaults. If you choose to enroll, you’ll have to decide how much to contribute and to which investments in the plan’s menu. And that’s not all.

A number of employers who offer a tax-deferred 401(k), 403(b), or TSP also offer a tax-free Roth alternative. The Roth has the same annual contribution limit and menu of investment alternatives, but no required minimum distributions (RMDs) after you turn 73 that tax-deferred accounts have.

With a Roth, you contribute after-tax income—rather than the pretax income you contribute to a tax-deferred account—so your current tax bill is not reduced. However, you can withdraw any earnings in the account free of federal income tax provided you are at least 59½ when you leave your job or retire and your account has been open at least five years. The contributions aren’t taxed at withdrawal either since you’ve already paid the tax. With a tax-deferred account, in contrast, you pay income taxes on all withdrawals at the same rate you pay on ordinary income.

You may be able to divide your contribution between a Roth and a tax-deferred account, and you can convert a tax-deferred balance to a Roth, although you’ll need to pay the tax that’s due. It’s a good idea to talk with your tax adviser before deciding whether converting makes sense for you.

TErms and conditions

As a condition of participating in a retirement plan and postponing taxes or, with a Roth, avoiding them entirely, you agree that you won’t withdraw from your plan account before you reach at least 59½, though you may qualify for an exception if you retire between 55 and 59½.

You may be able to borrow from your account balance if your plan permits loans. The loan, plus interest that is charged at market rates, is repaid with regular deductions from your salary. However, if you leave your job, you must repay any outstanding loan balance in full almost immediately or it is considered a withdrawal and becomes taxable.

dISTRibution basics

When you take a new job or retire, you can leave the balance of your retirement account with your previous employer, roll it over to a new employer’s plan if the plan accepts rollovers, or roll it into an IRA. All three alternatives maintain the tax-deferred status of the assets.

The option that’s best for you depends on a number of factors, including the investment choices available, the administrative and management costs, and personal preferences. It can be smart to consult an independent financial adviser as well as the human resources office where you work to seek comprehensive, unbiased advice.

If you’re leaving your job for any reason, including being let go or retiring, you also have the right to take a lump sum distribution in cash, though it’s rarely a good idea. Any taxes that have been deferred must be paid when you file your tax return for that year. In fact, 20% of the amount you ask to withdraw will be withheld to cover what you’ll potentially owe to the IRS. What’s more, you could be liable for a 10% tax penalty on the entire withdrawal if you’re younger than 59½.

If your account is in an employer’s plan or you’ve rolled it over to a tax-deferred IRA, you generally must begin to take RMDs when you reach 73. The amount you must withdraw each year is determined by your age and the balance in the account at the end of the previous plan year, which is often, but not always, December 31.

The exception is that you can postpone withdrawals if both of these conditions apply:

• You are still working for the employer sponsoring the plan
• You or your spouse don’t own more than 5% of the company you’re working for

When the Vest Fits

If you’ve been part of an employer’s retirement plan and leave your job for any reason, what happens to your account? That depends on the type of plan it is and how long you’ve participated.

You’re entitled to benefit from your participation if you’re vested, meaning you’ve worked for the employer for the required vesting period. The vesting period for each type of plan is set by federal law, and can never be longer than six years for a defined contribution plan or seven years for a defined benefit plan. It can be shorter at the employer’s discretion.

In a defined contribution plan, vesting requirements do not apply to any money you contributed or the earnings on those contributions. That amount is always yours. But if you’re vested, you have the right to any matching contributions your employer made plus any earnings on those contributions.

If you’re vested in a defined benefit plan, you’ll be eligible for a pension when you’re old enough to qualify, based on the employer’s rules. It’s worth keeping track of any pension accounts, as the income could be a welcome addition to your retirement budget, even if it’s only a modest amount.