Tales of Fatal 401(k) Rollover Disasters

Physicians with a 401(k) plan mayfind it advantageous to roll overthe assets into an IRA, but lurkingamong the many benefits are some dangerouspitfalls with costly repercussions.The following four stories are examplesof how a small mistake could have detrimentaleffects:

•A deposit into the wrong account.A doctor made a seeminglyharmless error on the transfer form: Hehad his 401(k) proceeds—$600,000—paid to himself instead of directly to hisIRA trustee. When the check arrived tohis home, he was out of town so his wifedeposited it into the couple's joint savingsaccount. The doctor assumed thecheck had been deposited into his IRAaccount, but when his next statementdidn't reflect it, he belatedly discoveredwhat had happened. It was exactly 62days later, which meant not only had his401(k) trustee deducted 20% of thefunds for federal withholding, he nowfaced a 10% penalty because the 60-daylimit for transferring the funds into anIRA elapsed.

•An administrative mistake.Another physician requested that hisformer employer transfer his 401(k)funds into his IRA. While he made nomistakes, the administrator who mailedthe funds to the IRA trustee accidentallyput a second check—the 401(k) rolloverof another ex-employee of the same clinic—into the envelope. The unquestioningadministrator and the physician'sIRA trustee, following brokerage procedures,promptly deposited both checksinto the physician's IRA account. Thedoctor's financial advisor spotted theinaccuracy on his IRA statement andwas able to unravel the error. Fortunately,the situation was reversible andno penalties were assessed, but had theadvisor not caught the mistake promptly,significant tax issues and penaltiescould have been triggered.

•Withdrawal blunder. Anotherpreventable situation arose when a surgeonwanted to deduct $50,000 fromher 401(k) to buy a car. Working withher financial advisor, she went throughthe transfer process by phone with thebrokerage firm that managed heraccount. When she checked her accountbalance a few days later, she wasshocked; instead of a $200,000 balance,she saw a big zero. It turns out anemployee at the brokerage firm cashedout her entire account, triggering a withholdingtax of roughly $50,000, ironicallythe amount she originally intendedto borrow. Again, the situation wasreversible, but it led to some needlessapprehension and a great deal of paperworkto correct what could have beenan expensive problem.

Conversion Advantages

Sometimes, physicians resist transferringfunds from a 401(k), even whenthe advantages of doing so are apparent.Whether it be out of loyalty to theorganization sponsoring the 401(k) orbecause they had a bad experience witha broker or commission advisor, manyphysician-investors believe they are betteroff accepting subpar performance intheir 401(k) account than risk theirmoney in strategies promoted by advisorswhose primary motivation maynot be aligned with the physician-investor'sbest interests—and that is avalid concern. However, if a physiciandecides that their current 401(k) is notmeeting their expectations, there arethree 401(k) distribution choices: takea lump sum distribution and pay thetaxes; roll over into a new 401(k) plan;or roll over into an IRA.

Rolling over 401(k) funds into anIRA when leaving an employer or retiringcan offer the investor many advantages.Assuming it is done on a direct,trustee-to-trustee basis, the entireamount is transferred to the IRA—notax is withheld, nor is there any currentincome tax due on the distribution—andallowed to continue on a tax-deferredbasis. The IRA offers far more investmentoptions, and a more effectivelydiversified portfolio can be created.

An IRA offers greater control, notonly over the choice of investments, butover administrative costs as well. Partialdistributions, for example, are allowed—something many 401(k) plansdo not permit. Qualified distributionsfor certain expenses, such as medical,disability, and death, can be taken withoutpenalty in an IRA.

Nonspousal IRAs offer beneficiariesthe ability to stretch out payments wheredesired, typically to reduce tax burdens.Some investments, such as certain annuityproducts, let the IRA investor controlthe distribution of funds to beneficiarieswithout the necessity of expensive trusts.

The Benefits of an Advisor

The likelihood of an error occurringwhen a financial professional attends to401(k) details is far less. For example, atthe time of one particular investor's layoffin the 1990s, he had about $100,000in his 401(k), which was rolled over intoan IRA. By the end of 1999, the value ofhis IRA had increased to just over$200,000. But the investor was dissatisfied;he said his portfolio wasn't growingfast enough. He had heard about enormousgains made by a friend in high-techstocks and decided he could do thesame by self-directing his IRA portfolio.He converted the investment portfolioconstructed by his advisor into a fewdot-com stocks and did well for a fewmonths, running the portfolio value upto almost $300,000. When the markettanked in 2000 and 2001, he lost almostall of his money. Eventually he returnedto his advisor with only a $25,000 balance,and admitted he wasn't good atpicking stocks—he said he got too emotionallyinvolved and lost his focus.

Some doctors are uncomfortablewith the concept of active investmentmanagement. They have become socomfortable with their 401(k) investmentchoices that, despite inferior performance,they resist making a change.They may have been too busy withtheir practices to spend much timeevaluating investment options whenthey initiated their 401(k), or theychose investments that made sense 20or 30 years ago and never reevaluatedthose choices since, despite lifestylechanges or the passage of time.

Younger investors starting a 401(k)don't worry themselves much aboutasset allocation or risk tolerance. Fewconsider going to a professional for acheckup. Their concern emerges asthey approach retirement. Of course,at that point, the options for recoverymay be limited. Many times financialadvisors can provide the guidanceinvestors need.

Andrew Macdonald is a principal ofMacdonald Financial Services, Windsor,Colo. He can be reached at aj@macdonaldfinancialservices.com or 970-686-6778. Mr.Macdonald is an investment advisor representativewith and offers Securities through Linsco/PrivateLedger, a registered investment advisor, memberNASD/SIPC. The opinions expressed in this article are forgeneral information only and are not intended to providespecific advice or recommendations for any individual. Todetermine which investment(s) may be appropriate for you,consult your financial advisor prior to investing.