Best practice for disposing of 401K, Roth 401K funds

[Mike_A1]

Hi There Experts,

I was laid off on 8/25/23 and I have been with my ex employer for just over 2 years. neither my 401K/Roth 401K is 5 years old, and I'm under 59.5 years. 

My goal is to legally avoid paying the 10% early withdrawal penalty.

I was told (by a rep of the plan admin) that I have multiple options:

1. Leave everything as is until I'm at retirement age

2. Direct rollover to my next employer's 401K/Roth 401K (who knows if and when this will happen!)

3. Take a lump sum cash out and pay taxes (on the 401K portion) and a 10% penalty (on all funds)

4. Take installment distributions over my life expectancy (say for the next 20 years), and I have the option to determine the frequency of the installments (annually, semi annually, quarterly, or monthly).

I got interested in option #4, and I asked if I'd still pay the 10% penalty for early withdrawal. The rep said, "We will withhold the taxes on the taxable portion of your installments (20%), but we will not withhold the 10% early withdrawal penalty. But, I guess since you are not 59.5 years old, you'll have to pay it anyway when you file your 2023 taxes. And you'd better ask a tax advisor to confirm".

So here I'm asking the experts. What do you guys think? Was the representative correct? And what would you advise me to do to avoid paying that penalty?

Thank you so much  for your help and insight!

Mike

[VolvoGirl]

Another option is to roll it over to a IRA & ROTH IRA accounts.  Then you will have more exceptions to the 10% early withdrawal penalty.

Here's info on IRA distributions

https://www.irs.gov/pub/irs-pdf/p590b.pdf 

[VolvoGirl]

Couple other links......

Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan. https://www.irs.gov/taxtopics/tc558

See Pub 575 page 36 Additional Exceptions
https://www.irs.gov/pub/irs-pdf/p575.pdf

..Distributions upon the death or disability of the plan participant.
..You were age 55 or over in the year you retired or left your job. (50 for qualified public safety employees)
..You received the distribution as part of "substantially equal payments" over your lifetime.
..You paid for medical expenses exceeding 7.5% of your adjusted gross income.
..The distributions were required by a divorce decree or separation agreement ("qualified domestic relations court order"),

[dmertz · Accepted solution]

I agree with VolvoGirl regarding #2 that direct rollovers to traditional and Roth IRAs would provide more flexibility than rolling over to another employer's 401(k) plan.  Unless you waive the requirement, the 401(k) plan is required to provide you with a written statement providing the details of your rollover options at least 30 days before making any distribution.  The appendix in IRS Notice 2020-62 provides the safe-harbor explanation that plans use to satisfy this requirement:  https://www.irs.gov/pub/irs-drop/n-20-62.pdf

Regarding #3, unless you have a penalty exception that applies, you'll owe a 10% early-distribution penalty on all taxable amounts.  That includes earnings in the designated Roth account.  Only your after-tax contributions will be free of tax and penalty.

Regarding #4, receiving a series of substantially equal periodic payments (SEPP) avoids the 10% early-distribution penalty if you do not modify the stream or payments before 5 years or you reach age 59½ whichever is later.  However, it makes no sense to do this if you don't actually need the money to live on.  If you modify the series of payments (other than as permitted with a one-time change to the RMD method of determining the payments) either intentionally or by mistakenly taking more or less from the plan than required, you'll owe a recapture of all of the 10% penalties that were avoided from the previous distributions under the plan.  Doing rollovers to traditional and Roth IRAs instead of doing #4 from the 401(k) plan will give you access to your original Roth contributions free of tax and penalty without doing a SEPP plan and if you later need money from the taxable portions you could establish a SEPP plan from the traditional or Roth IRA (although the periodic amounts would likely be lower due to starting the plan with a lower balance).

Tax withholding is nothing more than a down-payment on the tax liability eventually determined on your tax return.  For distributions that are eligible for rollover, the law requires the plan to withhold a minimum of 20% unless directly rolled over to another plan.  (Direct rollover means that the plan pays the distribution directly to the new qualified retirement account such that you never have constructive receipt of the funds rather than making the payment to you which you then roll over within 60 days.)  For a rollover-eligible distribution paid to you, you can provide the plan with a Form W-4P (for periodic payments) of Form W-4R (for nonperiodic payments) to request that more than 20% be withheld.

[NCperson]

@Mike_A1  I am kinda surprised you weren't given the treustee- to - trustee rollover to an IRA as an option.  That is simple to execute and avoids the 10% penalty. 

[dmertz]

The direct-rollover option in #2 includes rollovers to IRAs whether explicitly mentioned or not.  The plan is legally required to provide such an option as indicated in the safe-harbor explanation of rollover options.

[Mike_A1]

Thank you all who helped and took the time to write these replies. I really appreciate it.

My OP referenced a phone call I had with a plan's rep. This was, naturally, not comprehensive. I received my options, in writing, by mail, and it is indeed identical to the IRS's Safe Harbor explanation at https://www.irs.gov/pub/irs-drop/n-20-62.pdf

@dmertz when you say 

"Regarding #3, ... you'll owe a 10% early-distribution penalty on all taxable amounts.  That includes earnings in the designated Roth account.  Only your after-tax contributions will be free of tax and penalty."

I assume by "earnings" you mean those earnings that accrued due to investment activity conducted within the Roth account. Correct?

Another follow up question is: What are your recommendations for a low maintenance IRA/Roth IRA provider? My current plan's annual admin fees are almost negligible.

Thanks again to all of you.

Mike

[dmertz]

"I assume by "earnings" you mean those earnings that accrued due to investment activity conducted within the Roth account. Correct?"

Correct.

There are many brokerages that are IRA providers with no account maintenance fees and that have no-fee investment options where the only cost is the expense ratio of the particular investment.  Bankrate.com yesterday published a list of popular IRA providers:

https://www.bankrate.com/retirement/best-ira-accounts/

Banks also offer IRAs, but bank personnel tend to be inadequately trained, particularly with regard to the nuances of certain IRA transactions.