When It Comes to Retirement Distributions, 401(k)s Lack Valuable Flexibility

Good-quality 401(k) plans can have much to recommend them--ultralow-cost investment options and in some cases better legal protections than are afforded by IRAs. In fact, the Department of Labor's fiduciary rule for financial advisors, set to go into effect next April, requires advisors who suggest that a client roll his or her 401(k) assets over to an IRA be able to prove that the IRA is actually the best receptacle for the client assets.

There's a key area where IRAs have a clear advantage over 401(k)s: in-retirement distributions. Simply put, investors who decide to leave money in their company retirement plans and draw from them to meet their living expenses typically have much less flexibility and control over withdrawals.

Investors who have retired and want to pull money out of a 401(k) plan can typically choose from a short menu of choices (assuming they've decided not to roll the money over to an IRA): take a lump-sum distribution, buy an income annuity, or take their 401(k) distributions in installments (rather than pulling out a lump sum). And while the installment plan might seem, at first blush, to be the most appealing choice, an investor selecting that option surrenders a lot of flexibility. Specifically, those installment distributions must come out on a pro rata basis across all of the investments in the portfolio. The lack of flexibility imposed by the pro rata rules can diminish the benefits of staying put in a company retirement plan, even if that plan looks good from other angles.

401(k) Withdrawals Meet the Pro Rata Rule
In contrast with the pro rata rules governing the tax treatment of IRA distributions, which I wrote about last week, the pro rata rules for many 401(k) plans relate to which assets are sold to meet the investor's withdrawals, assuming he or she is taking those withdrawals as a series of installments over a period of years.

To help illustrate how these rules would work in practice, let's say 65-year-old Henry is planning to retire next year. He would like to keep his $800,000 balance in his 401(k) plan rather than rolling over the money into an IRA because the plan has a topflight lineup of ultralow-cost investment options that he can't gain access to via an IRA. (Granted, this is an increasingly unusual scenario due to the widespread availability of ultralow-cost index funds and ETFs on most brokerage platforms that offer IRAs, but bear with me.)

Let's further assume that he plans to take his withdrawals in annual installments to help meet his cash-flow needs in retirement; he's opted to take those payments as a percentage of his balance over a 25-year period, meaning that the dollar amount he withdraws will depend on his balance at the time of the distribution each year. (Installment amounts can be calculated in various ways.). His year 1 distribution will be $32,000 (4% of his balance).

If he has roughly 10% of his total $800,000 balance in cash ($80,000), 30% in bonds ($240,000) and the remaining 60% ($480,000) in stocks, the pro rata rules governing his plan mean that his first distribution would mirror that asset allocation. Of his initial $32,000 distribution, $3,200 (10%) of that amount would be pulled from his cash holdings, $9,600 (30%) would come from his bond positions, and $19,200 (60%) would come from his stocks.

In the second year of retirement, stocks embark on an epic slide. Due to a loss of about 20% in his equity holdings, his stock position, which started the year at $460,800 (his initial $480,000 less his $19,200 withdrawal from the prior year), has slumped to less than $370,000 at the time of his next installment distribution. His bonds have gained a little bit and his cash has held steady, which has helped his portfolio hold its ground. But the pro rata rules require that he take proportionate amounts from each of the holdings, so he has no choice but to raid the equity holdings for at least part of his withdrawal, even though they're depressed, and his equity position has dropped to just 54% of his total portfolio, down from 60% initially. Of his $682,752 total balance, he must withdraw $28,448 (his balance divided by his now-24-year withdrawal period); 54% of that amount will come from stocks, mirroring his portfolio's current equity weighting; 35% from bonds, mirroring the fixed-income percentage of his total portfolio, and 11% from cash.

While this equity holdings have slumped as a percentage of his portfolio, the pro rata rules have, in essence, forced him to sell his equity holdings low. It would have been ideal had he had the latitude to leave his equity holdings untouched while tapping bonds and cash for his distributions instead.

IRA Offers Much More Flexibility
By contrast, IRA withdrawals aren't governed by pro rata rules, giving a retiree more latitude to manage withdrawals in a way that aligns with portfolio strategy. If Henry were taking a buy and hold approach and using rebalancing proceeds to create cash flows, for example, he'd be able to pull his withdrawals exclusively from bonds and cash when his equity holdings are in the dumps; he'd extract money from equities only after robust stock-market rallies.

Within the confines of an IRA he could also implement a "bucket" approach to his cash flows, drawing money from his cash bucket within his IRA and regularly refilling it using income distributions, rebalancing proceeds, or both.

Of course, IRA investors aren't automatically in the clear when it comes to pro rata withdrawals; a retiree can inadvertently force pro rata distributions by holding an all-in-one fund such as an allocation or retirement income fund in retirement. When investors take distributions from such funds, as discussed in this article, the withdrawals come out based on the weighting of the underlying holdings--for example, an investor selling $10,000 of Vanguard Balanced Index (VBINX) to meet cash-flow needs would be selling $6,000 of her stocks and $4,000 of her bonds. To be sure, there's a lot to be said for the simplicity of holding a single fund, especially if its income distributions alone help the retiree meet his or her cash-flow needs. But for retirees who want to use rebalancing to periodically harvest profits in their portfolios, all-in-one funds are suboptimal. I compared the performance of a single-fund versus a multifund portfolio in this article.

When 401(k) Distributions Make Sense
As valuable as it is to have discretion over retirement withdrawals, there may be instances when staying put and taking withdrawals from a 401(k) is the right course of action, even if the installment distributions must be made on a pro rata basis. Among the key reasons to take withdrawals from a 401(k) would be if the investor values the creditor protections that can be stronger for 401(k)s than IRAs. (The specific creditor protections depend on the state in which the investor lives.)

Alternatively, a retired 401(k) participant may specifically value one or more of the investment options in the lineup. In that case, a partial rollover from the company retirement plan may be an option if the bylaws of the plan allow for it. The retiree could roll the bulk of her 401(k) assets into an IRA while leaving a portion of assets behind in the 401(k) plan's best investment option(s) and taking installment distributions from those. Such a partial rollover can make the most sense if the retained 401(k) holdings are low-volatility options like stable-value funds, as it will rarely if ever be an inopportune time to take withdrawals from them. By contrast, it's less sensible to take installment distributions from more volatile holdings, as there's a high likelihood that at least some of those withdrawals will need to come out when the account is at a low ebb.

It's also worth noting that 401(k) plans typically allow the participant who has opted for installment distributions to stop, change, or restart their distributions. That flexibility could give a retiree some leeway to tweak the plan if taking pro rata installment distributions seemed ill-advised at a given point in time. But it's also cumbersome.