Dear Dr. Don,
When I leave my present job at age 65, I will have a substantial 401(k) plan balance to invest. What is a good investment that will give me some income, but I will still be able to save?
— Sandy Selects
Know your options in terms of keeping the account with your employer, or rolling the money into an individual retirement account or into a Roth IRA. You should pay attention to annual fees, investment options and tax impact, especially with the possibility of a Roth IRA conversion.
If any of your 401(k) is invested in the company’s stock, a rollover into a traditional or Roth IRA often isn’t appropriate for the shares. Work with your tax professional in that situation to manage any net unrealized appreciation, or NUA, in the shares of the company’s stock. NUA is the difference between the current market value of the share and the average cost basis of the shares. The cost basis, or tax basis, is based on the purchase price adjusted for stock splits, dividends or any return of capital distributions.
If you just roll the shares into an IRA, the appreciation will be taxed as ordinary income when distributed out of the retirement account. Placing the shares in a taxable account allows the net unrealized appreciation to be taxed as capital gains, which may be at a lower rate than your marginal federal income tax rate. Just the cost basis is taxed as ordinary income.
You don’t say that you’re retiring, just that you’re leaving your present job at age 65. Your full retirement age for Social Security benefits, assuming you qualify, is age 66.
While you want to apply for Medicare four months before you turn age 65, even if you don’t plan to retire, you may want to wait on applying for Social Security retirement benefits.
The account is invested now. You just want to know how the investment allocation will change as the account transitions from an accumulation to a distribution portfolio. This will depend on your need for income, other income sources available to you and your goals in retirement.
If you stay in the 401(k) plan, your investment options are limited to those permitted by the plan. If you roll the balance into a traditional or Roth IRA, you have a wide range of investment options. Start first with the type of financial institution you want as custodian of the account. I like to categorize them as banks, brokerage or a mutual fund family. Remember, a bank IRA CD can be FDIC-insured, but a brokerage account or a mutual fund isn’t. Keep an eye on annual account fees and expenses as well as any trading costs or annual investment expenses.
Your retirement portfolio can generate income in many different ways. You could have a portion of the portfolio invested in dividend-paying stocks and another portion in CDs or bonds. Consider a CD ladder or a bond ladder so you aren’t making big interest rate bets by locking in long term or staying too short.
You could look into an immediate, fixed-rate annuity for a portion of the investment. The idea is to diversify across investments with an eye toward income but also remember that selling a winning investment puts money in your pocket, too. Gains are as good as income when everything being distributed from a traditional IRA is treated as ordinary income.
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