401(k) Enrollment, Investments
and Distributions
by Susen Friday

The Pension Protection Act of 2006 has made changes in a lot of areas of the retirement industry. Some of the things that can affect you as a participant are:

Auto Enrollment

Many employers, concerned that their employees are not saving adequately for their retirement, have decided to adopt an automatic enrollment feature for their 401(k) plans. This means new employees will be automatically enrolled in the plan when they are eligible. They will start out having a minimal amount deducted from their salaries and put into accounts established for them. This amount can be increased incrementally over time. The employees must receive advanced notice before the start of the next plan year in which they will be eligible. If they don’t want to participate, they can let the employer know in writing that they want to opt out. What if the employee wants to continue participating, but only at the minimal level? All they need to do is let the employer know about this in writing as well.

Qualified Default Investment Alternatives (QDIA)

Sometimes participants, for whatever reason, don’t bother to make any investment elections in their accounts. In the past, these participants usually ended up with their investment in a money market account. With the decline in the number of defined benefit plans and possible changes in Social Security, it was deemed by the retirement industry that this particular choice usually did not provide enough of a return to help fund retirement. As a result, the Department of Labor has defined the types of investments that a plan may use as a default for those participants who do not actively choose their investments. These investments include lifecycle or targeted-retirement date funds, balanced funds, and managed accounts.

As a result, a participant could find himself/herself enrolled in a 401(k) plan invested in one of the qualified default investments, without ever having made an active decision to do so.

The Pension Protection Act of 2006 also has some provisions that can affect the decisions of a terminated participant.

1. Beginning in 2008, participants will be able to make direct rollovers not only to a traditional IRA, but also to a Roth IRA – which the IRS considers a taxable event. In other words, it is now possible to roll your 401(k) account directly into a Roth IRA account, pay the taxes, and enjoy tax-free earnings growth for the life of the account. In addition, because it is now a Roth IRA, there is no required minimum distribution at the age of 70½. (Presently, there is an income limitation for those choosing to do this, but that could possibly be eliminated as early as 2010.)
2. In the past, the only beneficiary of a deceased participant’s qualified plan retirement account who could roll it to an IRA was the spouse. Non-spouse beneficiaries had to take a cash distribution and pay the taxes. Now, non-spouse beneficiaries may roll the distribution to an inherited IRA and continue to have the account grow tax-deferred.

WHAT TO DO WITH THAT 401(k)?

Basically, there are two groups of people who are faced with making the decision on what to do with their 401(k) accounts: those who have reached retirement age, and those who have changed jobs.

A July 2006 article published by Kiplinger’s Personal Finance, “401(k) Versus IRA,” cites a study done by Cerulli Associates, a financial research and consulting firm. The study, based on 2004 data, found that of those who had retired, 47% rolled their account to an IRA; 31% kept the account in the plan; and 21% cashed out.

A July 2005 press release from Hewitt Associates, a human resources and consulting firm, found that of those who terminated employment for reasons other than retirement, 23% rolled their account to an IRA; 32% kept the account in the plan; and 45% cashed out. Since the average length of time spent on a job is about five years, some people have had to make this decision more than once.

It is interesting to note a high percentage of former participants in both studies choose to take their distributions in cash. What are the consequences of doing this? First of all, this is a taxable event. That means that they will have to pay income tax on the proceeds, as determined by their tax bracket. In order to guarantee that the government is going to get a percentage of its share, 20% will be withheld by the plan before a check is even issued. Additionally, if the former participant happens to be less than 55 years old, the IRS will assess a penalty of 10% on the account balance.

Unfortunately, it seems like many of the people who change jobs use the funds to take care of current financial needs without realizing what they are giving up. As luck would have it, there are many calculators on the Internet that can illustrate the difference of cashing out and spending versus keeping the money in a deferred account. (You can find one by simply doing a Google search for “retirement calculators.”) The above example assumes that the participant is 30 years old, has an account balance of $10,000 and a growth rate of 8%. This participant’s tax rate is 25% and he/she plans to retire at the age of 67.

As you can see, there is a big difference in taking the cash upon termination or letting it continue to grow in a tax-deferred account. Changing jobs and cashing out several employer plans over time can be a very costly course of action.

What are the options to stay in a tax-deferred account?

•   Do nothing; stay in the plan of the former employer.

    Some participants choose to remain in their plan. Depending on the structure and features of your plan, this may or may not be allowed. You would need to check with your plan administrator to see if this option is available to you. Your investment options will be limited to those offered by the plan. This can either be to your advantage or not. Many plans offer institutional funds that are not available in the retail marketplace. If you really like these funds, you may want to stay. If you are looking for a wider array of choices, it may be better to roll the account to an IRA.

    Also, if you remain in your plan, you are eligible to take distributions from the plan, penalty-free, at the age of 55 as opposed to 59½ for an IRA. This could be important for those who think they may need access to that money.

    If permitted, another advantage of staying in your plan is your account will not be subject to creditors under ERISA (Employee Retirement Income Security Act). In other words, your retirement account will be safe not only if you file for federal bankruptcy, but also from judgments other than bankruptcy, regardless of state law.

•   Rollover to a new employer’s 401(k).

    This option is only for those terminated participants who have changed jobs. The ability to do this will depend on the plan of your new employer, since some do not permit rollovers from other plans. In addition, if this is your choice you may have to wait until you meet the eligibility requirements of the new employer’s plan and you will be limited to those investment options offered by the new plan.

    This alternative actually has some attractive features. Just as in staying in your old plan, you will have the ability to withdraw cash at the age of 55 without penalty, as well as the same protection from creditors. Additionally, you may be able to borrow against your account if the new plan permits loans. (Some people like to know this is available to them to fall back on, even if they don’t use it.)

    Many people are aware that when they reach the age of 70½ they must take their required minimum distribution each year from their traditional IRA whether they are working or not. But, if they are still working, the participant is not required to take a required minimum distribution from their employer sponsored plan and, in fact, may still contribute to it as long as they continue to meet the plan’s eligibility requirements. This is not an option
for IRAs.

    Imagine how this could benefit someone who had rolled over his/her 401(k) accounts from successive jobs, acquiring a substantial account balance. If they are still working and earning enough to live on, they would be able to have their account remain intact
and continue growing tax-deferred for either when they want it, or to pass it along to their beneficiaries. In contrast, if they had rolled previous balances to an IRA, they would be forced to take the required minimum distributions at age 70½ .

•   Rollover to an IRA.

    The last option is to roll your 401(k) account to either a traditional or Roth IRA. By doing this, you will have an almost unlimited universe of investments to choose from. You will also not be limited as to when you can change your investment choices. However, there will be a 10% penalty on withdrawals for those under the age of 59½, and you would not be able to borrow from your IRA.

    If you are still employed and successive employers do not permit rollovers from other plans this may be your only option besides cashing out.

    Protection from Creditors
Section 224 (e) (1) of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 offers some protection from creditors for IRAs. Under this law, assets of both traditional and Roth IRAs are protected from federal bankruptcy up to $1 million. Depending on future litigation, those IRA accounts resulting from a rollover of a qualified plan may be eligible for that protection on a larger amount. Note: This protection has not been extended to judgments awarded in other courts where individual state creditor protection laws apply.

    As mentioned earlier in this article, new legislation has made it possible to roll your 401(k) account directly into a Roth IRA. Income taxes, however, must be paid in the year of the rollover into a Roth; the balance will continue to grow tax free and there will be no required minimum distribution. This course of action is attractive to those who believe that taxes are going to go up in the future and that their tax bracket will either stay the same or go up in retirement. They would rather pay now at a lower rate than later at a higher rate. (Up until this year the only IRA eligible for rollovers from plans were the traditional IRAs. The rationale was that the income tax bracket for most retirees would be lower than when they were still employed; subsequently, they would be paying less tax.)

    Whichever IRA is chosen, would depend on your on personal situation and should be discussed with your tax professional.

IS THERE ALWAYS A CHOICE?

Some participants are in a plan for such a short period — and depending on what is going on in their lives — actually forget they even have an account. Many sponsors do not want to maintain the accounts of terminated participants because in many instances, some fees are charged on a participant basis. This increases the fees of both the plan and remaining participants. In addition, it is difficult to keep track of many terminated participants, particularly those with low balances.

The Economic Growth & Tax Relief Reconciliation Act of 2001 established how plans with mandatory distributions will be handled. By adopting this EGTRRA amendment, the plan will reduce the mandatory cash-out threshold to $1000 or less. If the balance is between $1001 and $5000 it can be rolled to an IRA in the participant’s name with his/her last known address at a financial institution of the plan administrator’s choosing.

HOW TO ROLL OVER TO AN IRA

There are two kinds of rollovers to an IRA account:

1. The direct rollover occurs when the account is liquidated and assets are transferred to the IRA designated by the participant without him/her ever taking physical possession of it. In this case, there is no 20% withholding.

2. An indirect rollover occurs when the check, less the 20% withholding, is made out and sent directly to the participant. He/she then has 60 days to deposit both the check and the 20% that was withheld into an IRA account. If it is not done within that timeframe it will be considered a cash distribution and subject to taxes and possible penalties.
IRAs are available through many different financial institutions such as banks, mutual funds, brokerages, and insurance companies.

The first step is to complete an IRA account application at your chosen financial institution. Once you receive an account number you will fill out the distribution papers from your plan indicating how you wish to receive the distribution. If it is a direct rollover, it will either go directly into your account or a check will be sent to you in that institution’s name for your benefit.

Many plan and IRA providers have agreements with intermediaries who can facilitate the rollover process seamlessly. The participant can literally complete the rollover process online with the click of
a mouse.

Muhlenkamp Fund IRA applications are available by calling our Client Service Department (877)935-5520 x4 or visiting our website at www.muhlenkamp.com.

Perhaps you would like to use the Muhlenkamp Fund in a brokerage IRA account with other investments. If that
is the case, we will be happy to let you know if it is available through the broker of your choice.   

Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax adviser or legal counsel for advice and information concerning their particular situation. Neither the Fund nor any of its representatives may give legal or tax advice.