Published Thursday, January 28, 2010 at: 7:00 AM EST
If you’re leaving your company because of a downsizing or a switch in jobs, you wouldn’t think of going without cleaning out your office. But what about the assets in your 401(k) plan? All too often, departing employees leave behind their retirement plans without giving much thought to the consequences.
According to a recent survey, about half of the 401(k) participants who leave their jobs have not moved the funds a year later. Though there’s no penalty for keeping your funds in an ex-employer’s plan, you can’t continue contributing to the account. Also, you may have concerns about how the account will be administered after you’ve gone, and you could face obstacles in recovering the money if the company goes under.
But you don’t have to let your assets languish in a former employer’s plan. You have three other principal options: take a cash distribution, move the funds to a new employer’s plan, or roll over the assets to an IRA.
Take a cash distribution. Frequently, an employee will elect to take a lump-sum distribution from a 401(k) plan when leaving a job, especially if money is tight. But that could result in a hefty tax bill. The amount representing pre-tax contributions and earnings in the 401(k) is taxed at ordinary income rates reaching as high as 35% on the federal level. If you’re under age 59½, the IRS will generally tack on a 10% “early withdrawal” penalty. And don’t forget about state and local taxes and state penalties.
Besides incurring tax liability now, this approach means forfeiting the future benefit of tax-deferred savings and putting a hole in your retirement plan. After 60 days have passed, you’ll have lost the opportunity to transfer the funds to another tax-advantaged plan. And don’t think you’ll receive the full balance of assets in your account. The employer’s 401(k) administrator will automatically withhold 20% of the payout, regardless of your personal circumstances. Unless you have a dire need for funds, you would do better choosing one of the other options.
Transfer assets to a new employer’s plan. If you find another job, you often can move your 401(k) balance to another 401(k) or other tax-qualified retirement plan available through your new company. That way, your assets will continue to grow tax-deferred without interruption. This direct transfer is also exempt from the early withdrawal penalty, and there’s no tax withholding as long as you arrange a trustee-to-trustee transfer from one plan to another. If you take the funds yourself, you have 60 days to complete the transfer, but 20% will be withheld, and you won’t be able to recover that money until you file your tax return for the year of the transfer.
The main potential drawback to this option is that you’ll be limited to the investment choices in your new employer’s plan. Those may be better or worse than you had before, but the third option—rolling over assets to an IRA—is likely to provide more investing flexibility and a wider menu of choices.
Move your account balance to a rollover IRA. Just as when you transfer assets to a new 401(k) plan, you may continue tax-deferred savings by rolling over your retirement savings to a traditional IRA. And here, too, you can avoid automatic tax withholding by using a trustee-to-trustee transfer. Otherwise, you have 60 days to complete the rollover without triggering income tax liability or an early withdrawal penalty.
This may be the most advantageous approach. Again, an IRA generally offers greater investment flexibility, letting you invest in a wide variety of stocks, bonds, and mutual funds, compared with 401(k) choices that tend to be more limited. And the IRA may give you greater control over distributions during retirement.
In addition, employees now also have a fourth option—rolling over employer plan funds to a Roth IRA that provides tax-free distributions during retirement. But moving money to a Roth means paying income tax on the untaxed portion of your account, unless you have large tax deductions that you can claim to offset this extra income.
Almost all of these options are likely to be preferable to leaving your 401(k) account with your former employer. We can help you explore the possibilities and find the best approach for your situation.
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