One of the most important questions you face when changing jobs is what to do with the money in your 401(k) plan. Making the wrong move could cost you thousands of dollars or more in taxes, penalties and lower returns.
Consequences of Cashing Out
Let’s say you work five years at your current job. For most of those years, you’ve had the company take a set percentage of your pretax salary and put it into your employer’s plan. Now that you’re leaving, what should you do?
The first rule of thumb is to leave it alone. Resist the temptation to cash out. The worst thing you can do when leaving a job is to withdraw the money and put it in your bank account. Here’s why:
If you decide to have your distribution paid to you, the plan administrator will withhold 20 percent of your total for federal income taxes. So if you had $100,000 in your account, you’re already down to $80,000.
Furthermore, if you’re younger than 59 1/2, you’ll generally face a 10 percent penalty for early withdrawal come tax time. Now you’re down another 10 percent from the top line to $70,000.
There is an exception to the 10 percent early withdrawal tax penalty for 401(k) plans if you separate from service during or after the year you reach age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan). IRAs, SEPs, SIMPLE IRAs, and SARSEPs do not qualify for the exception.
In addition, because distributions are taxed as ordinary income, at the end of the year, you’ll have to pay the difference between your tax bracket and the 20 percent already taken out. For example, if you’re in the 32 percent tax bracket, you’ll still owe 12 percent, or $12,000, which lowers the amount of your cash distribution to $58,000. (If your tax bracket is less than 20%, you may qualify for a refund, depending on your overall tax liability for the year compared to what was withheld or paid in estimated taxes for the year.)
But that’s not all. You also have to pay any applicable state and local taxes. Between taxes and penalties, you could end up with little over half of what you saved, short-changing your retirement savings significantly. Finally, you will miss out on any future tax-deferred growth those assets would have produced had they remained in the retirement plan.
What Are the Alternatives?
If your new job offers a retirement plan, the easiest course of action is to roll your account into the new plan. A “rollover” is relatively painless to do. Contact the 401(k) plan administrator at your previous job, who should have all the necessary forms.
The best way to roll funds over from an old 401(k) plan to a new one is to use a direct transfer. With the direct transfer, you never receive a check, you avoid all the taxes and penalties mentioned above, and your savings will continue to grow tax-deferred.
Many employers require that you work a minimum length of time before you can participate in their 401(k) plan. If that is the case with your new employer, one solution is to keep your money in your former employer’s 401(k) plan until you are eligible for the new one. Then you can roll it over into the new plan. Most plans let former employees leave assets in their old plan for several months or longer.
If you’re not happy with the fund choices your new employer offers, you might opt for a rollover IRA instead of your company’s plan. You can then choose from hundreds of funds and have more control over your money. But again, to avoid the withholding hassle, use direct rollovers.
60-Day Rollover Period
If you have your former employer make the distribution check out to you, the Internal Revenue Service considers this a cash distribution. The check you get will have 20 percent taken out automatically from your vested amount for federal income tax.
But don’t panic. You have 60 days to roll over the lump sum (including the 20 percent) to your new employer’s plan or into a rollover IRA. Then you won’t owe the additional taxes or the 10 percent early withdrawal penalty and, depending on your overall tax liability for the year, you might receive a refund of some or all of the 20% withheld. But keep in mind that in your rollover you will have to make up for the withheld 20% with funds from another source. Otherwise, the withheld amount will be treated as a distribution and subject to any applicable taxes and penalties.
Leave It Alone
If your vested account balance in your 401(k) is more than $5,000, you can usually leave it with your former employer’s retirement plan. Your balance will keep growing tax-deferred.
However, if you can’t leave the money in your former employer’s 401(k) and your new job doesn’t have a 401(k), your best bet is a direct rollover into an IRA. The same applies if you’ve decided to go into business for yourself. You can still continue to enjoy tax-deferred growth.
Questions about IRA rollovers? Help is just a phone call away.