One of the most important questions you face when changing job is what to do with your 401(k) money. Making the wrong move could cost you thousands of dollars or more in taxes and lower returns.
Lets say you put in five years at your current job. For most of those years, youve had the company take a set percentage of your pre-tax salary for your 401(k) plan. Now that youre leaving, what should you do?
The first rule of thumb is, its wisest not to touch the money.
The worst thing employees can do when they leave their employer is to withdraw money from their 401(k) plans and then keep it.
If you decide to have your distribution paid to you, the plan administrator will withhold 20% of your total for federal income taxes. So if you had $100,000 in your account and you wanted to cash it out, youre already down to $80,000.
And if youre not yet 59 1/2, youll get a 10% penalty slapped on for early withdrawal. So now youre down another 10% from the top line, to $70,000.
Then at the end of the year, youll have to pay the difference between your tax bracket and the 20% already taken out. Thats because distributions are taxed as ordinary income. For instance, if youre in the 33% tax bracket, youll still owe 13%, or $13,000. Now your cash distribution is worth $57,000.
Thats not all. You might have to pay state and local taxes. After all that, you could end up with little over half of what you had saved up.
Whats more, if you decide after 60 days to roll over your remaining balance, the government wont let you.
When you cash out, you take that hit (from penalties) and you shortchange your retirement savings.
Lets Look At The Alternatives
Before you touch your 401(k), find out if you new job offers a retirement plan. Its easy to roll your account into the new plan. Contact your former plan administrator for the forms.
The best method is to have the money sent directly from you old 401(k) plan to the new one. With the direct transfer, you never receive a check. Direct transfers let you avoid the taxes and penalties mentioned above. Your savings will continue to grow tax-deferred until you retire.
One word of caution: You may not be able to participate in the new plan right away, so be sure to check on that. Many employers require you work a minimum of a few months before you can start your 401(k).
One solution: Stay with your former employers 401(k) plan until the new one is available, then rollover into the new one. Most plans let former employees leave their assets several months in the old plan.
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% taken out from your vested amount for federal income tax.
But dont panic. You have 60 days to roll over the lump sum (including the 20%) to your new employers plan or into a rollover individual retirement account. Then you wont owe the additional taxes or the 10% early withdrawal penalty.
If youre not happy with the fund choices your new employer offers, you might opt for a rollover IRA instead of your companys plan. You can then choose from hundreds of funds.
You have more control over the money, therefore, in an IRA. But again, to avoid the withholding hassle, use direct rollovers.
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 employers retirement plan. Your lump sum will keep growing tax-deferred until you retire.
Check with your former employer to get the details. If your plan wont let you stay and your new job doesnt have a 401(k), your best bet is to do a direct rollover into an IRA.
Perhaps youve decided to work for yourself or prefer to manage your money yourself. If so, you could roll over your distribution into an IRA. Youll also avoid having to pay the stiff cash withdrawal fees.
Corporate America and the financial services industry have done everything possible to make this a painless and easy process.
Once you turn 59 1/2, you can begin withdrawals from your 401(k) plan or IRA without penalty. Your withdrawals will be taxed as ordinary income.
You dont have to start taking withdrawals from your 401(k) unless you retire after age 70 1/2. With an IRA you must begin a schedule of taxable withdrawals based on your life expectancy when you reach 70 1/2, whether youre working or not.