For many Americans, the largest chunk of their nest eggs will come from company-sponsored retirement plans. And many realize that decisions regarding this payout could have serious ramifications for the rest of their lives. What you decide to do with your 401(k) funds when you leave a job will be based on your financial circumstances, your investment needs and the transaction’s tax consequences. Some issues to consider:
Taking the cash: The temptation when you leave a job may be to use those savings to satisfy short-term spending urges, even if doing so will mar your long-term retirement goals. Nearly half of employees cash out their 401(k)s, with younger workers and those with smaller balances more likely to do so, according to research from Hewitt Associates. People view these balances as found money, but there are few instances when cashing out makes sense.
If you cash out, your company probably will cut you a check for 80% of the funds. The rest will be withheld for federal taxes. Taking that lump-sum distribution also could bump you into a higher tax bracket that year. You also may be hit with a 10% tax penalty if you are younger than 59½. Even worse, you have to start over building retirement savings. For this reason, it is wise to calculate the effect of any applicable taxes and penalties before you elect to take a distribution. Many people are surprised at how greatly this reduces the amount of their payout.
Regret the hasty withdrawal? You have 60 days from when you get the distribution to roll it over into an IRA or your new employer’s 401(k) to avoid the penalty. If you miss this deadline because of a mistake by your financial institution, the IRS grants an automatic extension. Taxpayers could also get a break when unusual circumstances, such as an illness, prevent them from getting the money back in time.
Rolling over: When you transfer your 401(k) into an IRA rather than leaving it in the company’s plan, you keep taxes deferred while making it easier to keep track of your investment.
When you change jobs, you lose touch of what’s happening at the company. That means the company could change investment options, and you likely won’t be first to know.
Also consider rolling money over into an IRA when:
• You want more investment options than are available in the 401(k) plan. Your company plan may have a set menu of prescreened investment options, but you can usually invest in individual stocks, mutual funds, or certificates of deposits in an IRA. You will have more investment choices along with investment tools and advice by rolling over your 401(k) into an IRA.
• You want control over your money. If you’ve changed jobs often during your career, you may have retirement funds strewn all over. An IRA lets you consolidate this money in one place.
• You are planning to pass the money to your children. IRAs give you greater flexibility in transferring these funds to beneficiaries, including letting your heirs stretch withdrawals over a long period of time rather than taking a lump sum.
• You’re considering buying a home. If you’re a first-time home buyer, you can withdraw up to $10,000 penalty-free from your IRA to put toward the purchase of a principle residence. Even if you’ve owned a home in the past, you may qualify: The law defines a “first-time home buyer” as someone who hasn’t owned a principal residence in the two years prior to the home purchase.
• You plan to use some of the money to pay for college expenses for you, your spouse, your children, or your grandchildren. If the money is in an IRA, the IRS will waive the 10% penalty for these uses, although you’ll still have to pay income tax on the withdrawal.
• You’re unemployed and need to buy health insurance. If out of work, you can take penalty-free withdrawals from your IRA to pay the premiums. To qualify, you generally must have received unemployment benefits for at least 12 consecutive weeks. The rule also applies to premiums paid under COBRA, a federal law that allows you to continue your former employer’s coverage for up to 18 months, says Bob Scharin, senior tax analyst for Thomson Reuters.
• You’re considering taking an early retirement. Ordinarily, if you take withdrawals from your tax-deferred retirement savings (IRA’s) before age 59 ½ you have to pay a 10% penalty. You can avoid this penalty, however, by taking advantage of the “substantially equal periodic payment” rule. This rule allows you to avoid the early-withdrawal penalty as long as you agree to withdraw a specific amount of money for five years or until you turn 59 ½ whichever is longer. You’ll still owe income taxes on your withdrawals. PLEASE NOTE: Legally, there’s no prohibition against taking periodic payments from a former employer’s 401(k), but some plans limit the types of distributions you can take. Keep in mind, though, that this exception (i.e.: periodic payments from employer’s 401(k) ) is limited to workers who are at least 55 when they leave their jobs. If you retire at 54, you’re not eligible, even if you wait until you’re 55 to withdraw the money. You won’t run into this problem if you roll your money into an IRA.
None of these penalty-free withdrawals are available if you leave your money in a former employer’s 401(k) plan, says Catherine Golladay, vice president for 401(k) advice and education at Charles Schwab. To minimize the risk of mistakes and to keep your money invested throughout the process, ask for a direct transfer (trustee-to-trustee transfer) from your 401(k) to an IRA. The money is moved directly to the IRA without a check being written. Or have the check made out to the financial institution that will manage the IRA and have your name listed as well. Preceded with the letters F.B.O) (Example: F.B.O Jane Smith) F.B.O. meaning For the Benefit Of: Jane Smith
• Staying in company plan: Many companies will allow you to stay in their 401(k) plan if you have more than $5,000 in the account.
• Rolling retirement into new employers plan: If you’re changing jobs, you might be able to roll the money over to your new employer’s plan, it allows rollovers. You will be limited in your investment choices but some 401(k) plans offer low-cost institutional funds that are only available in employer-sponsored retirement plans. Be sure to check out your new employer’s investment lineup first though.
If you have $1,000 to $5,000 in your 401(k) and do nothing, your former employer is usually required to roll your money into an IRA.
Reasons to leave money in a 401(k) plan:
• You can borrow from it. You can’t borrow from an IRA.
• Some people like having a set menu of funds picked by the company, rather than having to wade through hundreds of investment options on their own.
• Expenses may be lower in company-sponsored plans. Large employers are often able to negotiate investments discounts. But compare costs because higher fees may apply to 401(k) investors who have left the company.
With both 401(k)s and IRAs, you generally have to wait until you are 59 ½ to withdraw money without facing a tax penalty. Only exception with 401(k) plans: If you leave the company and are at least 55 years old, you can take distributions without penalty.