Alan Klayman is CEO of Klayman Financial LLC. He served as a vice president at Fidelity Investments, worked as a financial planner for American Express, and built fixed income strategies on Wall Street at The First Boston Corporation. At CreditCards.com, he writes Maturing Loans, a weekly feature in which he answers readers' questions about retirement and debt issues.
Dear Maturing Loans,
Can you be taxed on money you withdraw from your
401(k) retirement plan to put into a bank CD? With the economy the way it is
now, I would hate to lose most of the money I have put into my 401(k) because
of the stock market.
-- Pam
Dear Pam,
Your question really brings up a
number of issues that are on many people's minds: the stock market, retirement
nest eggs, investing, and how retirement plan assets (like a 401(k)) are
treated.
Let's start with a distinction.
There are different types of investment accounts that have specific rules
associated with them. Let's look at two broad categories: retirement and
nonretirement.
Retirement accounts have names like
IRA, 401(k), 403(b), pension and profit sharing. Nonretirement accounts have names
like individual account, joint account and tenants in common.
In these accounts you can have
investments. For example, you can own a bank CD in an IRA, and you can also own
a bank CD in an individual account. The type of investment is not necessarily
tied to the type of account you have. You can own mutual funds in your joint account,
and you can also own mutual funds in your 401(k).
Which brings us to some of the
rules. A 401(k) plan is an employer-sponsored defined contribution plan, which
means that your employer sets up the plan, and you choose how much money you
want to put into the plan each year. That amount usually is a percentage of
your earnings and is subject to limitations set by both your employer and the federal
government.
One advantage of a defined
contribution plan, like a 401(k), is that the government allows you to make
contributions with tax advantages. Your tax advantages are set by the type of
plan your employer chooses. Typically, the plan allows you to deduct your
contribution from your income, allowing you to grow your money tax-free now,
and then you pay taxes when you use the money at a later date. Some plans do
not allow for a tax deduction based on your contribution, but your money still
grows without being taxed. When you use the money at a later date, you don't
pay taxes on the original investment or the growth of the account (this is
called a Roth 401(k)).
So back to your question. If you
are withdrawing money from your 401(k), the first question that needs to be
asked is whether your plan allows withdrawals. Many 401(k) plans do not allow
withdrawals unless they are for hardship purposes, or they allow you to borrow
from your plan, but then you must pay back what you borrowed along with a set
interest rate.
If you are no longer working for
the employer that enrolled you in the 401(k), then you can roll the 401(k) plan
over to an IRA and invest in just about anything you want, including bank CDs,
mutual funds, and many other types of investments. Withdrawals from 401(k) plans
are taxed. Borrowing is taxed if you do not pay it back. Borrowing is not
taxed if you pay it back. Rolling over your plan from a 401(k) to an IRA is
not taxed.
Which leads to the last point. Does
getting out of your mutual funds -- 401(k) plan or any other type of plan --
really make sense? Unfortunately, my crystal ball is broken, so I can't tell
you what will happen in the future, but I can give you these guidelines. Keep
in mind everyone's situation is different. You need to seek the help of financial
professional and perhaps a tax adviser in order to get questions answered that
specifically address your situation. If your goal to use your money in your 401(k)
(or any other plan for that matter) is long term, then invest in a diversified
portfolio that is professionally managed (like mutual funds). If your goal is
to use this money in the short term, you should look at fixed investments.
Thanks for your question, see you
back here next week.
Alan Klayman is creator of MyIncomeStrategy.com and CEO of Klayman Financial LLC. Klayman specializes in retirement income planning, business management and planning, estate planning, tax-advantaged investing, trust investment management, professional money management, insurance and annuities, mutual funds, fixed income securities, and institutional and personal retirement plan administration.
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