One of the decisions you face when changing jobs is what to do with the money in your 401(K). Making the wrong move could cost you thousands of dollars or more in taxes and lower returns.
Let's say you are fully vested in your previous company’s 401(K) plan. Now that you're leaving, what should you do? First, you need to know that you don’t have to make a decision right away; you have 60 days to decide what to do. Absolutely resist the temptation to cash out. The worst thing an employee can do when leaving a job is to withdraw the money from their 401(K) plan and put it in his or her bank account.
If you decide to cash out and 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 and you wanted to cash it out, you're already down to $80,000. Then, if you're younger than 59 1/2, you'll also face a 10 percent penalty for early withdrawal come tax time. Now you're down another 10 percent from the original amount of $100,000 to $70,000.
Also, 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 33 percent tax bracket, you'll still owe 13 percent, or $13,000. This lowers the amount of your cash distribution to $57,000. But that's not all. You might also have to pay state and local taxes. Between taxes and penalties, you could end up with just a little over half of what you had saved, short-changing your retirement savings significantly.
Note: 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) there is an exception to the 10 percent early withdrawal tax penalty. This applies to 401(K) plans only. IRA, SEP, SIMPLE IRA, and SARSEP Plans do not qualify for the exception.
What are the Alternatives?
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 lump sum will keep growing tax-deferred until you retire. Most people don’t like to keep their 401(K) with their previous company for simplicity and other reasons.
If your new job offers a retirement plan, then a good course of action is to rollover your account into the new plan during the 60-day period. This 401(K) to 401(K) rollover is the same process as 401(K) to IRA and if you have a small amount, under $5,000, this may make more sense simply to have fewer accounts to follow. Keep in mind that many employers require that you work a minimum time (e.g. three months) before you can participate in a 401(K). If that is the case, again a rollover to your IRA is an option or you may be able to keep your money in your former employer's 401(K) plan until the new one is available. Then you can roll it over into the new plan. Most plans let former employees leave their assets in the old plan for several months.
I often recommend that clients roll their account into Individual Retirement Accounts (IRAs) before the 60-day period ends. Referred to as a "rollover" it is relatively painless to do. There are more investment options available to the investor in an IRA and the asset isn’t held at the company it’s held by you, giving you more control over your money. For example, all of the investment options that you might currently have with IFP are available to you through an IRA. The 401(K) plan administrator at your previous job should have all of the forms you need.
If you had the good fortune of having a Roth 401(K) available to you, or you had made post-tax contributions to your 401(K), then some of that rollover and future earnings can be sheltered from future taxes. The best course of action is to roll over the Roth 401(K) or post-tax amounts into a Roth IRA and the Traditional 401(K) or pre-tax amount into a Traditional IRA. In a Traditional IRA the funds are not subject to tax until it is taken out of the IRA account. And in a Roth, the contributions and the earnings can be withdrawn tax-free.
60-Day Rollover Period
The best way to roll funds out of an old 401(K) plan to an IRA is to use a direct transfer. With the direct transfer, you never receive a check, and you avoid all of the taxes and penalties mentioned above, and your savings will continue to grow tax-deferred until you retire.
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) into a rollover individual retirement account (IRA). Don’t be tempted to spend the money before you do so.
Don't hesitate to call if you have any questions about 401(K) or IRA rollovers.