Distribution from a 401(k) plan resulting from termination of employment presents a chance to gain control of the funds while maintaining the tax-deferred status of the money. This control can only be obtained through the use of a self-directed IRA. To know which choice to make, you need to understand the different options available to you.
When a 401(k) plan is distributed, you only have three options. The options are:
- The funds may be distributed to you directly, in which case the company must withhold 20% for taxes.Unless this distribution is rolled over to 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.
- Funds can be transferred to a securities-based custodian, where the custodian will limit your investment options to what they sell. In almost all cases, your only options are securities (stocks and bonds) and mutual funds.
- Funds can be transferred directly to a self-directed IRA custodian, where you can select a variety of assets, such as gold, real estate, or private business financing, but also include securities (stocks and bonds), if desired.
Options two and three are simple and have been chosen by most people 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 now on. Option two will retain the tax-deferred status of the money, but your investment options are limited to what the securities company allows you to invest. Many times, the options available to the IRA are more limited than those offered to non-IRA clients.
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 expert financial advisors. No more.
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 permitted by law, not just securities
- Follows the same rules as any other IRA regarding contributions, distributions, and IRS reporting
- You cannot invest in life insurance, collectibles, or anything that benefits the IRA beneficiary or family members
- Not the same as “self-directed” IRAs offered by securities-based custodians
- The SD-IRA owner (you) finds the investment on your own or with the help of an investment expert with knowledge of off-market investments.
Also, you should know:
- The Self-Directed IRA Custodian does not sell investment products or provide investment advice.
There is an additional unique opportunity in 2010 where you can take your tax-deferred IRA and convert it to a tax-free “Roth” IRA. You will have to pay tax on the converted amount BUT, Roth IRAs are tax free at the time of distribution. In 2010 there are also additional provisions regarding the payment of taxes 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 instead of just one. You can ask your accountant what this will mean for you regarding your retirement plan.
The SD-IRA used to include only a small percentage of all IRAs in the country. In recent years, this percentage has risen significantly and is growing rapidly due to overwhelming concerns about investing in securities.
In general, people who invest in an SD-IRA are primarily invested, in order of popularity, in:
Real estate, both leveraged and unleveraged
Private stocks that are not publicly traded
Loans, such as first and second mortgages secured by a deed of trust
bridging loans
Prayed
Other non-traditional investments
SD-IRA custodians are a small but growing financial service. There are several options available if you decide to roll your 401(k) into an SD-IRA. When choosing a custodian, consider these factors: willingness to provide education, availability for questions when the investment is imminent, and thorough knowledge of SD-IRA rules, to maintain your tax-deferred status.
The Self-Directed IRA provides nearly unlimited flexibility and control over your retirement assets. Distribution from your 401(k) plan has given you the opportunity to take your retirement out of the stock market and direct your plan toward assets that will grow for your future.
Catherine Wynne is a director of Entrust New Direction IRA, Inc., a self-directed IRA management company affiliated with The Entrust Group, leaders in self-directed plans since 1981. On the web at www.ndira.com