Given the continued weakness in the economy and an unemployment rate still above historic norms, now is a good time to review the financial planning issues clients face when they leave a job or are laid off. A CPA’s timely and proactive advice can have a lasting effect. Here are 10 planning considerations:
1. Maintaining Liquidity
Once clients are aware of an impending job change or separation, they must start thinking of cash needs and sources. I encourage my clients to file for unemployment insurance as soon as possible, given the lengthy processing time. In addition, opening a home equity line of credit can help with large, one-time expenses, and it may be advantageous to consolidate higher-interest credit card debt. Since rates are currently low, clients should explore whether refinancing a mortgage makes sense as well, assuming they can find a bank that will issue a loan. Clients who want to open a home equity loan or refinance (and will still have enough resources to make additional or higher payments) should do so while they are still employed, or they may have a hard time qualifying for a new loan.
2. Qualified Retirement Plans
Clients face several decisions on their 401(k) or other qualified retirement plans. Foremost, before leaving a company, employees should always review the plan for any outstanding loan balance and the plan’s options regarding the loan. Frequently, 401(k) plan loans must be paid off upon termination of employment. If liquidity is a concern, a better suggestion is to talk with the employer to see if it is possible to leave the loan in place and pay it back over time. I’ve seen some employers work with their employees on this.
If a client needs money from a 401(k) after leaving the company permanently, at least two options are available for those under the minimum retirement age of 59½ (Sec. 72(t)(2)). The “separation from service” distribution is available for those 55 and older. A second distribution option is the “substantially equal periodic payments" method. Both allow the client to immediately begin accessing 401(k) money without owing the 10% early withdrawal penalty, although, of course, income taxes still apply. A good planning tip is to encourage clients with one or more accounts they have maintained with previous employers to consolidate them into one with the current employer before leaving the company. That way, they can take advantage of the separation-from-service distribution, which is available only for the balance with the most recent employer. As always, if you are not also advising the client on taxes, it is important to encourage the client to consult a tax adviser regarding a rollover, contribution or distribution of plan assets.
3. IRA Transfers
Clients may also consider a rollover of a qualified plan to an IRA or a Roth IRA. A direct trustee-to-trustee transfer should avert withholding requirements. A number of pros and cons related to rollovers should be evaluated on a case-by-case basis. One non-tax-related consideration, for example, is the potential for reduced creditor protection, since Employee Retirement Income Security Act (ERISA) rules don’t apply to IRAs.
4. Net Unrealized Appreciation
Before rolling over or transferring a 401(k) to an IRA, clients and their CPAs should evaluate whether the net unrealized appreciation (NUA) rules apply. If clients own company stock in a 401(k), employee stock option plan (ESOP) or other qualified retirement plan, they are eligible for NUA tax treatment. Under these rules, the NUA in a distribution of employer securities that is attributable to employee contributions is not included in income at the time of distribution. Thus, the taxation of the NUA amount is deferred until the securities are sold, and the NUA is taxed as a capital gain—not as ordinary income. The exclusion of NUA from income does not apply to rollovers; thus, NUA is not subject to the limitations on rollovers of nontaxable amounts.
This is a great area for CPAs to add value. Given that long-term capital gain rates are fixed until 2013 and the potential for increased income taxes still lingers in the future (not to mention, for high-income taxpayers, the 3.8% tax increase imposed on net investment income and the additional 0.9% Medicare tax set to take effect in 2013), NUA is an especially important tax strategy to consider now. There are disadvantages, of course, including the 10% early withdrawal penalty, if applicable, and income tax due on the basis of the stock distributed. In addition, the client loses the tax-deferred growth available in an IRA rollover, and the wisdom of continuing to hold the employer stock at all should be reviewed (see tip No. 8 below).
5. Restricted Stock
Clients who made a Sec. 83(b) election on restricted stock have already paid income taxes on stock they then forfeited upon leaving the employer that granted it. Commonly, those with enough influence at a job with a new company will negotiate a make-whole payment for any restricted stock they forfeited upon leaving their previous employment. However, most taxpayers are without such recourse except in rare circumstances. The Sec. 83(b) election is generally irrevocable but may be revoked with the consent of the IRS if the client can prove a “mistake of fact.” For details, see “Restricted Stock Awards and Taxes: What Employees and Employers Should Know,” and Rev. Proc. 2006-31.
6. Deferred Compensation
For those with a deferred compensation plan through an employer, now is a good time to review the plan details. Pay special attention to the distribution schedule. Some plans have a set distribution schedule that the client elected when he or she first contributed money, while others allow the employee to elect a payout option upon termination or retirement. The key is timing. Deferred compensation plans that allow the employee to select a distribution schedule after employment ends usually require doing so within 30 or 60 days after leaving. Otherwise, the distribution will revert to a default schedule. This is common in Sec. 457 “top-hat” deferred compensation plans.
Clients need to balance their liquidity needs and the credit risk associated with deferred compensation plans. One of my clients recently retired from a major investment bank with money in three deferred compensation plans, all through the same employer. She had significant cash and savings, so immediate liquidity was not a concern. She was comfortable with her former employer’s credit risk, so electing the annual payout over 10 years made the most sense. Stretching the payouts over a number of years rather than opting for a lump sum allowed her money in the plan to continue to grow tax-deferred as well as helping with budgeted annual income needs. However, had she wanted to stretch the payments out over 20 or 30 years, I suspect the credit risk conversation might have been different.
7. Company Stock Options
Executive clients who leave a company with employer stock options have a few additional planning issues to address. First, the client should review vested options and make sure to exercise them prior to expiration. This sounds obvious, but I’ve heard some embarrassing stories of executives waiting for the right price to strike and ultimately forgetting to exercise before the expiration date. Also, clients have three months from the date of termination to exercise incentive stock options or the options convert to nonqualified stock options (Regs. Sec. 1.422-1(a)(1)(i)(B)). Finally, if clients do want to exercise their options, ensure they have liquidity available to pay the income tax, or you can suggest a “cashless exercise” and have the tax paid out of the sale of the stock. Clients who want to hold on to stock options can also hedge the risk by buying a long-term put that matches up to the options’ expiration date. The cost of the put option needs to be weighed.
8. Holding Onto Company Stock
Planning with company stock revolves around liquidity needs and risk tolerance. Developing a plan for divesting a client’s company stock is a good idea to increase diversification. Equally important, clients should consider hedging company stock they hold. A covered call strategy or using a “collar”—a simultaneous purchase of a put and sale of a call—may limit future appreciation but serves the important purpose of also limiting downside risk, which clients always seem to feel more acutely. Other possible disadvantages to options include their cost and their own downside risk.
9. Pension Plans
For those lucky few with a defined benefit pension, several planning opportunities are worth evaluating. First, though, clients should understand the risk. Many people think of a pension as guaranteed income. However, it is guaranteed only if the company participates in the Pension Benefit Guaranty Corp. (PBGC). Second, if the plan is covered by the PBGC, only a portion of the pension income may be guaranteed; there is a cap. Clients should check the PBGC website at pbgc.gov for details or contact their benefit administrator. Also, clients can better understand their downside exposure by reviewing the maximum monthly guarantee tables to determine their monthly cap if the company goes bankrupt.
The client should also evaluate payout options, including lump sum and single or joint life. If the pension is not covered by the PBGC and there are serious creditor concerns, a lump-sum rollover to an IRA is a reasonable solution, if available. A lump sum can also make sense if the client and adviser want more control over investment selection or to leave inheritable assets. The single or joint life options should be compared with investing the lump sum in a commercial annuity, which may provide more income. A possible disadvantage, of course, is creditor risk of the annuity company, although most are covered by a state guaranty association up to a certain amount. Finally, there is the age-old “pension maximization” strategy for a couple of opting for the single-life payout from the pension and using a portion of the money to purchase life insurance on the payee.
10. Health Insurance
COBRA. Arguably, the most important coverage clients can maintain is their health insurance. COBRA is an obvious choice for maintaining coverage during a period of unemployment but not always the right choice. Private plans can offer more flexibility in plan design and may even save the client money. A good resource is ehealthinsurance.com, or the client can find a broker via the National Association of Health Underwriters at nahu.org. If clients lose health insurance through the former employer’s group plan, they may have the right to “special enroll” in a spouse’s health plan without having to wait for the next open enrollment. Timing is crucial, since there is a 60-day window from the date of termination of coverage under the group plan to enroll in COBRA, which can be retroactive to termination of employment.
Health savings accounts. An HSA is portable. If a new employer offers an HSA, the client can consolidate the old plan into the new one, unless the client retires, in which case special rules apply. As with an IRA, a client can make only one HSA rollover to a new plan per year, but can make an unlimited number of trustee-to-trustee transfers to that same account, so correct administration is important here. Balances within HSAs can be accessed tax-free for qualified medical expenses, including long-term-care insurance—subject to limits—COBRA premiums, health care coverage while receiving unemployment insurance, and Medicare premiums (other than Medigap), as long as both spouses are 65 or older and on Medicare.
Flexible spending accounts. Unlike HSAs, flexible spending accounts (FSAs) do not allow distributions for health insurance premiums. Equally important, FSAs have a “use it or lose it” rule, meaning balances cannot be carried forward from one year to the next. Before 2012, there was an opportunity to transfer an amount from an FSA to an HSA if the employee was contributing to the FSA prior to 2006—it’s best to have the client consult with the benefit administrator or tax adviser.
AWARENESS AND PROMPTNESS ARE KEY
These are just some of the planning opportunities and decisions for the recently unemployed. Others include whether to continue group life and disability insurance. The key is creating awareness and acting quickly, given the time constraints. The days after a client terminates employment are busy, filled with resume writing, job hunting, networking and soul searching. It is also when clients’ immediate financial planning choices can have a lasting effect on their goals. Engaging your client in a conversation about these topics can potentially benefit the client and ultimately help solidify your relationship.
CPAs’ timely and proactive advice can help clients who leave their job or are laid off manage their finances as they weather a period of uncertainty.
Maintaining adequate cash during such a period may entail refinancing a home or taking out a home equity line of credit, provided the client has resources for repayment. Or, if eligible, the client may want to take a qualified distribution from a 401(k) or other qualified retirement plan. If the client has borrowed from the plan’s account, however, the outstanding balance may have to be repaid upon leaving employment.
Transfers and conversions of IRAs or Roth IRAs may be beneficial during such times. Any net unrealized appreciation in an employer plan may be eligible for favorable tax treatment. Some clients also may face considerations of deferred compensation plans or restricted stock grants, especially if they have made a Sec. 83(b) election.
Other areas to explore include defined benefit pension plans and continuation of health insurance coverage.
Michael Aloi ( email@example.com ) is a Certified Financial Planner with Summit Financial Resources Inc. in Parsippany, N.J.
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The Tax Adviser article
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