If you’re leaving your company because of a downsizing or a switch in jobs don’t forget 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 by Charles Schwab, almost half of the money held in 401(k) plans by employees who left their jobs during the first quarter of 2008 had not been moved a year later. While there is no penalty for leaving your 401k with your prior employer, there are benefits to moving the account. In fact, 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.
The cash distribution option should be considered the last resort, hardship option only. Under this scenario, you elect to take a lump-sum distribution from a 401(k) plan when leaving. Unfortunately, that election 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 you still have to worry 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 leaving a gap in your retirement plan. After 60 days have passed, you’ll have lost the opportunity to transfer the funds to another tax-advantaged plan. The final kicker? The employer’s 401(k) administrator will automatically withhold 20% of the payout, regardless of your personal circumstances. Again, this is the last resort, hardship option only.
If and when 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. Avoid taking the funds yourself, because if you do, 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.
Finally, you can role the 401k account into an Individual Retirement Account (IRA). This may be the most advantageous approach. 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.Beginning in 2010, all employees now also have a fourth option—rolling over employer plan funds to a Roth IRA that provides tax-free distributions during retirement. (Previously, Roth conversions were allowed only in a year in which your adjusted gross income didn’t exceed $100,000.) 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.
