Start preparing now for your transition
Note: This article represents the views and opinions of Brightworth and has not been reviewed or endorsed by your company or any of its employees.
Whether you’ve been at your company for 3 years or 30 years, you probably have many questions about the financial aspects of leaving and how it may affect your financial future. Common questions we hear include:
- Do I have sufficient assets to provide for my retirement, or do I need to look for another job?
- How much money do I need to earn at my next job to stay on track financially?
- Are there any strategies to help lessen the tax burden of my payouts?
- What happens to my stock awards?
- Should I rollover my 401(k) or leave it where it is?
- What are my options regarding health, life, and disability insurance?
- What other aspects of my financial life might be affected by my departure?
These and many other considerations are presented in this short article to help you start preparing for your transition. The following are 7 key areas to consider:
#1: Severance Payment
Severance is commonly paid in a lump sum a few weeks after your separation date. The payment will be subject to ordinary income tax, and you typically cannot defer any of the payment to your 401(k) or deferred compensation accounts as the payment will be made following your separation date. Taxes will be withheld, but typically at a standard rate of 22% for Federal tax purposes (37% for employees whose cumulative earnings exceed $1 million in the year of payment) plus applicable state, FICA, and Medicare tax. Since this payment could bump you into a higher tax bracket, it is important to consider whether the standard Federal withholding at 22% will be sufficient to cover your tax on this income. You may need to set aside extra cash from your payment to cover the full tax. For some people, the year they receive a severance payment could be the biggest income tax year of their life, so implementing tax reduction strategies is critically important to maximizing your wealth that year.
Some people may be in a position to save their severance payment and invest for the future, but it is important to consider whether you may need to keep the proceeds readily available until you’re sure of your cash flow needs. We often find that such a “windfall” presents a good opportunity to tackle other goals such as debt pay-down, college savings, or emergency fund replenishment.
Ensure that you fund the maximum allowable amount to your 401(k) plan ($19,500 in 2020, or $26,000 for age 50+) prior to your separation date. This is an excellent savings opportunity that will soon be lost, so be sure to take advantage while you can. If an adjustment is needed to your paycheck before year-end that will reduce your take-home pay, remember that you will be receiving your severance payment shortly after separation, which can offset some of this impact.
Some 401(k) plans provide the option of contributing to the 401(k) on a traditional pre-tax basis, or to a post-tax Roth 401(k). If your contributions are not already being made entirely on a pre-tax basis, switching any remaining contributions to traditional pre-tax is one step you can take to help reduce your taxable income for the year.
After leaving your company, you have a few options regarding what to do with your 401(k) plan. First, you can leave your account in the company plan as it is. It will continue to be invested in the investments you have chosen and will continue to grow on a tax-deferred or tax-free basis, depending on whether your contributions were pre-tax or Roth. You can continue to access your account on the 401(k) website. You will not be required to withdraw funds from your account until you reach age 72, when the IRS requires that distributions begin.
If you are between the ages of 55 and 59 ½ you may want to give special consideration to whether you may need to take a withdrawal from your 401(k) plan prior to age 60. Generally, any withdrawals from a retirement account prior to age 59 ½ are subject to a 10% early withdrawal penalty. However, a special rule allows for penalty-free withdrawals from your 401(k) prior to age 59 ½ if you are at least age 55 during the calendar year that you separate from service. In some cases, it makes sense to leave some or all of your 401(k) assets in the 401(k) in case access is needed prior to age 60.
A second option is to roll your 401(k) over into another company 401(k) plan, or to an IRA and/or Roth IRA. Be sure you understand the components of your 401(k) deposits as this dictates what type of account the money should be rolled over to, while avoiding taxes. Any pre-tax dollars should be rolled over to a traditional IRA, with the check made payable to the IRA custodian. Any Roth 401(k) dollars should be rolled to the custodian of the Roth IRA. Lastly, if you have an ‘after-tax account’ where you made after-tax contributions over the years, take advantage of rolling the after-tax contributions dollars into your Roth IRA. It’s a unique strategy that many high-income earners can take advantage of whereas funding a Roth IRA in the past has been unavailable given IRS income limits. The after-tax contributions can also be deposited into your personal checking or brokerage account.
At Brightworth, we counsel clients on how best to make these important rollover decisions based on their unique circumstances.
For employees who have purchased company stock for a very long time and have low-cost basis in their shares, the Net Unrealized Appreciation (NUA) strategy may be attractive. The NUA strategy allows you to distribute some or all of your company stock from the 401(k) into a brokerage account, and pay capital gains tax on shares sold. Ordinary income tax is due on the cost basis of those shares, but not on the entire fair market value. When coupled with a charitable giving strategy, NUA has the potential to dramatically reduce the overall tax impact of distributing out and selling stock assets. This is a sophisticated strategy and an expert should be consulted before beginning this approach.
Finally, many people are surprised to learn that assets such as 401(k)s and IRAs are not distributed at your death according to what your will says. Instead, distribution is based on the beneficiary designation you have placed on each account. Therefore, it is critical that you check the beneficiary designations on your 401(k) and IRA to ensure that the beneficiary designations are appropriate and work in concert with your overall estate plan.
#3: Deferred Compensation Plan
If you met the eligibility requirements to participate in this non-qualified retirement plan, you likely had the option to defer a large amount of your annual base salary and bonus each year. It is possible that you have accumulated significant assets in the deferred compensation plan over the years and you will want to understand the timing of the distributions. Since this is a non-qualified retirement plan, assets cannot be rolled over to an IRA and, instead, must be distributed to you.
Distributions from the plan will begin within a specified period following your separation date and be made according to the schedule you selected during the enrollment period each year, when you chose to defer income to the plan. Typical distribution options are to receive a lump sum or payments over 3-15 years. Distributions will be fully subject to ordinary income taxes, so over 40% of your withdrawal could be lost to taxes depending on the amount of the distribution and your other income sources in the year of distribution. Careful coordination of these withdrawals with your other income sources or tax deductions may help avoid tax on deferred compensation distributions at the highest tax brackets. If your situation allows, consider accelerating or deferring other income to a year other than the year in which you will receive a large deferred compensation distribution so as to potentially avoid taxation of this income at the highest tax rate. Moreover, if possible, consider grouping tax deductions together into the year in which receipt of a large distribution will take place. For someone who is charitably inclined, a donor-advised fund can help in this regard.
A donor-advised fund allows an individual to gift assets to the fund and immediately receive the corresponding tax deduction, but defer making a gift to the ultimate charitable recipient until a later date. Therefore, a donor can make a significant gift representing several years’ worth of charitable giving to the donor-advised fund and capture the full tax deduction that year, but delay making the gift to the ultimate charitable recipient until an appropriate time.
If your deferred compensation balance will remain in the plan for several years, it is important that your investment allocation be coordinated with your other investments and overall financial plan. In addition, you should periodically rebalance your account to keep it in line with your chosen investment allocations. We provide our clients with specific investment recommendations based on their unique financial situation.
#4: Stock Awards
Many companies offer long-term incentive awards to key employees. Stock awards often consist of stock options, restricted stock, and/or performance-based restricted stock. For many of our clients, their stock awards are one of the largest, if not the largest, assets on their balance sheet. Therefore, it’s wise to have a strategy to unwind these stock positions once you’ve learned your position is being eliminated.
The awards have vesting schedules that may be accelerated based on the criteria in your severance package, and some awards may expire providing no value. It’s important to account for this in your financial plan and understand the cash flow and tax implications of your stock strategy to maximize the after-tax value.
When restricted stock or performance-based stock awards are released, the fair market value of the award is taxed at ordinary income tax rates and reported on your pay stub. Your holding period for tax purposes begins on the date shares are released to you. Consequently, selling shares immediately after release should result in negligible capital gains tax. If you sell within 12 months, any gain will be taxed at short-term capital gains rates, i.e. ordinary income tax rates. Waiting 12 months to sell following the release of shares will qualify any capital gains to be taxed at long-term capital gains rates – a maximum rate of 23.8% for Federal purposes (don’t forget state taxes, too). For example, if 1,000 shares are released to you in February 2021 and the stock is trading at $150/share, $150,000 is taxed to you as ordinary income. If you wait until March 2022 to sell the shares at $160/share, the $10 per share gain is taxed as a long-term capital gain.
Finally, it is important to monitor what the release of additional company stock means to your overall concentration in that stock. For our clients entering retirement, we recommend limiting their concentration in a single stock to no more than 10% - 15% of their investment portfolio.
#5: Pension Plan
While less common now, some companies offer pension benefits. In most cases, you are able to take your pension benefit with you when you leave or elect to defer receiving pension benefits until a later date. Run estimates of your benefit amount at different benefit commencement dates before you transition out of your company, and keep them for your records.
In addition to choosing when to begin receiving your pension benefits, you will need to decide what payment option to choose. Options often include an annuity payable only for your lifetime which is typically the highest payment amount, or payments based on both your life and the life of a surviving spouse or beneficiary. You have the option of choosing what percentage of your payment a surviving spouse or beneficiary will ultimately receive and this decision will impact your pension benefit amount. For example, a retiree may have a Single Life Only Annuity option that pays a monthly benefit of $2,000 for the duration of their life only. Alternatively, they may have the option of a Qualified Joint and Survivor Annuity payment that lasts for their life and the duration of a spouse’s life. However, their monthly benefit amount may then be reduced to $1,850 with a surviving spouse’s benefit of $925 per month.
Finally, some pension plans provide the option to take a lump sum. If this is the right decision for you, roll this to an IRA to avoid income taxes upon the payout of the lump sum pension.
With regards to both when and how to receive your pension benefits, it is important to consider where your income will come from over the next several years in order to understand what your cash flow needs will look like. You will want to take inventory of income sources such as other work earnings, Social Security, investment portfolio withdrawals, etc. to understand where any gaps may exist in your needs for income and how your pension benefit may help to “fill the gap.”
There are other factors to consider in your decision as well. Age, health, future work income, and how soon you will need to start living off your investment portfolio are important considerations. We build projections for our clients to help analyze what income versus expenses will look like in retirement, where additional income might be sourced, and how their pension income fits into their bigger retirement picture.
As a fee-only wealth management firm, Brightworth does not sell insurance products. However, insurance planning is an important part of a well-designed financial plan, and we consult with clients on how best to structure their insurance program. It is common for employees to have the bulk of their life, disability, and health insurance coverage through the company group plans, so it is important to understand what your retirement from the company means for your insurance coverage.
Regarding health insurance, determine whether you are eligible for a company retiree health plan. Also, evaluate the merits of electing COBRA for a period of time following your separation date, until you get another job or become eligible or an alternative medical plan (Medicare or an individual plan).
We understand health insurance is a sensitive and stressful topic, and we work with our clients to ensure they have the optimal strategy in place to avoid gaps in their healthcare coverage needs.
For life insurance, evaluate how much coverage you should maintain, for how long, and what the cost is to convert your group coverage to an individual policy versus getting a new policy elsewhere. Typically, you can convert your group policy to an individual policy with no evidence of insurability. Keep in mind that group life insurance policies are often more expensive than private policies as you get older, so it may be worth shopping for a private policy if you need to maintain coverage.
Your disability insurance coverage often ends on your separation date. Individual private coverage is expensive and may be difficult to qualify for, so if you need to keep working you may want to be mindful of the group disability coverage offered by a future employer.
If you have funds in the Health Savings Account (HSA), your account can stay there. You will not forfeit these funds. Note that if you have not made your full annual contribution to the HSA via payroll deductions by your separation date, you can still fund any remaining contributions from your personal funds and claim a tax deduction on your tax return as late as April 15 of the following year.
#7: Investment Portfolio
The cornerstone to your long-term financial success is a well-designed and constructed investment portfolio. Your investment portfolio is critical to building and preserving wealth and should be designed to fit your cash flow needs, time horizon, risk tolerance, and tax objectives. Successful investing requires a long-term perspective and disciplined approach in order to avoid short-term, emotional mistakes. Having a coordinated and comprehensive strategic asset allocation is the foundation for your entire portfolio.
While working at your company, it is possible that the majority of your investment assets are concentrated in the company 401(k) plan with limited investment choices. After your separation date, you may choose to roll these assets into an IRA where the investment choices are plentiful and offer significantly more flexibility in designing an optimal asset allocation. While a greater number of choices is nice, it can also be overwhelming to distill such a large offering down to a viable portfolio. Different stages of life and circumstances will dictate an appropriate mix of investments, cash flow planning, and how best to optimize the tax aspects of your portfolio.
Brightworth offers investment management services to our clients using sound investment disciplines carefully coordinated with customized, innovative financial planning. Our ultimate objective is to enhance clients’ wealth while protecting their capital over the long term. Through ongoing monitoring and evaluation, periodic tactical shifts, and flexible managers, we are able to take advantage of opportunities and manage risks in the near term for our clients.
Understanding the mechanics of your severance package and how they integrate into your personal financial situation is critical in making correct decisions as you move into the next chapter of your professional or retired life. Our team has helped numerous corporate executives and professionals make similar decisions and navigate this complicated process. The process of transitioning can feel overwhelming, but we want you to know that we are ready to assist. We will develop a personal strategy for you to help ensure you are prepared to take full advantage of your severance package. We want you to have a clear understanding of your financial future and well-being.
This paper provides general information about severance packages. If there is any error or inconsistency between this paper and the official plan documents defining the terms of your company plans, the official plan documents for each benefit and compensation plan will govern.