The distribution of a 401(k) plan resulting from the termination of employment presents an opportunity to gain control of the funds while still maintaining the tax-deferred status of the money. This control can only be gained by using a self-directed IRA account. In order to know what choice to make, you must understand the different options available to you.
When a 401(k) plan is distributed, you have only three options. The choices are:
- The funds can be distributed to you directly, in which case the company must withhold 20% for the payment of taxes. Unless this distribution is rolled into an IRA within 60 days, it will be a taxable event and the total amount distributed, including the 20% withheld, will be taxed at your current income tax rate.
- The funds can be transferred to a securities-based custodian, where the custodian will limit your investment choices to what they sell. In nearly all cases, your only options are securities, (stocks and bonds), and mutual funds.
- The funds can be rolled directly into a self-directed IRA custodian, where you can select a variety of assets, such as gold, real estate, or private company funding, but also including securities (stocks and bonds), if you choose.
Options two and three are straightforward and have been chosen by most individuals in this situation because they are quick and easy. Unfortunately in option one you must pay taxes and the funds will lose their tax-deferred status. In other words, in option one; any earnings on this money will be taxed as ordinary income from this point forward. Option two will retain the tax-deferred status of the money but your investment choices are limited to what the securities company allows you to invest in. Many times the choices available to the IRA are more limited to those offered to non-IRA customers.
Option three, using a self-directed IRA custodian, presents the most flexibility. For many years self-directed custodians were unknown to the public and typically only available to high net-worth individuals with knowledgeable financial advisors. No longer.
Some facts about what a self-directed IRA (SD-IRA) is:
- like any other IRA in all respects except that the SD-IRA allows the IRA to invest in anything allowed by law, not just securities
- Follows all the same rules as any other IRA with regards to contributions, distributions and IRS reporting
- Not able to invest in life insurance, collectibles or anything that benefits the IRA beneficiary or family members
- Not the same as the “self-directed” IRAs offered by securities based custodians
- The SD-IRA owner (you) find the investment on your own or with the help of an investment expert who has a knowledge of investments outside of the stock market
In addition, you should know:
- The Self-Directed IRA custodian does not sell investment products or give investment advice
There is an additional one time opportunity in 2010 whereby you can take your tax-deferred IRA and convert it into a tax free “Roth” IRA. You will have to pay taxes on the amount converted BUT, Roth IRAs are tax free upon distribution. In 2010 there are also additional provisions regarding the payment of taxes that are due on the conversion that will be beneficial to you. You will be allowed to spread the taxes due on the converted amount over two years rather than just one. You can ask your accountant about what this will mean to you with regards to your retirement plan
The SD-IRA used to comprise only a small percentage of all IRAs in the country. Over the past few years this percentage has increased significantly and is growing rapidly due to overwhelming concerns about securities investments.
Overall those individuals invested in a SD-IRA are primarily invested, in order of popularity, in:
Real estate, both leveraged and non-leveraged
Private, non-publicly traded stock
Lending, such as first and second mortgages secured with a deed of trust
Other non-traditional investments
SD-IRA custodians are a small but growing financial service. There are several choices available to you should you elect to rollover your 401(k) into a SD-IRA. When choosing a custodian, consider these factors: willingness to provide education, availability for questions when the investment is eminent and in-depth knowledge about the rules of the SD-IRA, in order to maintain its tax-deferred status..
The Self-Directed IRA provides nearly unlimited flexibility and control of your retirement assets. Your 401(k) plan distribution has provided you with the opportunity to move your retirement out of the stock market and direct your plan towards assets that will grow for your future.
Catherine Wynne is a principal in Entrust New Direction IRA, Inc., a self-directed IRA administration company affiliated with The Entrust Group, leaders in self-directed plans since 1981. On the web at www.ndira.com
Catherine Wynne is President of Entrust New Direction IRA, Inc, which provides account administration and recordkeeping services for Individual Retirement Arrangements and other plans to clients who want to control their own investment decisions. Entrust New Direction is committed to providing clients and their financial advisors with the best information and quality education. We believe that informed clients will be more likely to recognize and take advantage of investment opportunities available to their self-directed IRAs and other self-directed qualified plans. We provide information not only through our web site, but also through seminars and workshops throughout the West, as well as radio shows, books and CD-ROMs.