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Moving on, Rolling over

watering dollars

By Paige Radke

The 401(k) plan is a powerful employer-based, tax-advantaged way to save for retirement. But what workers do with their 401(k) money before retirement can have grave consequences.

Among 401(k) participants who left their employer in 2013, 35% prematurely cashed out, according to Fidelity Investments, the nation’s largest manager of 401(k) assets. An early withdrawal can result in tax penalties, additional taxes, as well as years of lost compounded tax-deferred growth for retirement savings.

Typically, American workers change jobs every five years, the Bureau of Labor Statistics reports, with about 4.5 million Americans quitting or losing their job each month. A new report by the Employment Benefit Research Institute declares that “one of the most important decisions” of 401(k) participants is what to do with their accounts when they leave their employer.

A 401(k) is a qualified retirement plan established by employers to which employees can make salary reduction contributions. Many employers match contributions on behalf of employees, and earnings are tax-deferred.

With high job turnover and rising rates of premature withdrawals, investors need to know their options for 401(k)s. You have many things to think about, including penalties, tax implications, cost, convenience and control. Some options:

Cash Out

401(k) plans encourage long-term saving for retirement with pre-tax payroll contributions and tax-deferred growth. But they penalize early withdrawals, commonly with a 10% tax on funds taken out before age 59½, with some exceptions, including workers who leave an employer at age 55 or older. Plus, the IRS considers withdrawals as income, subject to federal, state, and local income taxes and possibly pushing you into a higher tax bracket.

So if you have a combined income tax rate of 30% and are subject to a penalty of 10%, cashing out your $100,000 401(k) would cost you $40,000 and leave you with only $60,000. This is not your best option.

Rollover to a new 401(k) plan

You usually have an option to keep your 401(k) where you had it through your former employer. But if your new employer offers a 401(k) plan – where you can get automatic payroll deductions and maybe even contribution matches – that may be a better choice. Three points to consider:

  • Fees. Switching to the new plan may cost you additional fees that make the move less beneficial.
  • Investment options. You want to make sure that the plan you select provides the right investment choices for your financial needs.
  • Timing. You may have to wait to transfer the assets until the next enrollment period, or even after you have been on the job for an entire year.

Workers leaving an employer for retirement should keep in mind that 401(k) plans often don’t allow periodic distributions to retirees after age 70½.

Indirect Rollover to an IRA

If you prefer to handle the transfer of funds yourself, you can do so through an indirect rollover. It involves personally withdrawing the money from your current 401(k) and depositing it into an individual retirement arrangement, or IRA.

This gets complicated. You have 60 days to deposit all the money into a new account or incur early-withdrawal penalties. However, the IRS requires 401(k) administrators to withhold 20% of the funds to cover the possibility that you won’t roll them over into a new plan. That means you must use personal savings or other funding to make up the difference and then seek to get the 20% back when you file your taxes.

Rollover to an IRA

There are three main benefits to rolling over your old job’s 401(k) directly into an IRA.

  • Control. Employer-run plans typically offer a relatively low variety of investments. “By rolling over to an IRA, you have more flexibility,” said Steve Giles, vice president and investment advisor at Landaas & Company. “You are not limited to the funds available to the employer’s plan and can instead pick from your own selection of funds.”
  • Consolidation. Especially if you already have other investment accounts or a pre-established IRA, rolling over your 401(k) into an IRA can more efficiently show how all the pieces of your investment puzzle fit together, instead of trying to assemble it through various scattered accounts.
  • Ease. As opposed to the indirect rollover option, since the money is transferred from one financial institution to another, you should not have to worry about withholding rules or tax penalties. When the money moves, it never touches your hands, and you can avoid the 20% withholding.

Saving for retirement is one of the most important yet overlooked benefits of your work life. Getting yourself into a 401(k) program or starting an IRA early allows you to take advantage of compounded earnings and tax benefits. While you may change jobs multiple times in your life, making the right moves with your 401(k) will help provide financial security for your future.

Learn more
For Internal Revenue Service rules on rollovers, please click here.
“Smart 401(k) Investing – Moving Your 401(k),” from the Financial Industry Regulatory Authority

Paige Radke is an associate at Landaas & Company. 

(initially posted July 31, 2014; updated Oct. 23, 2015)

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