Don't Let Your 401k Get Lost in the Shuffle
Target Audience: Business Owner, Individual Tax Issues Interest, 401k and Retirement Planners, Employers, IRA vs 401k Evaluators
Even under the best of circumstances, changing employers involves a lot of details and stress. Amongst all the challenges, one of the things that can get lost in the shuffle is your 401(k) plan account.
When it comes to your 401(k), your best bet is usually to roll over your plan into either a 401(k) at your new employer or your IRA. Why? Because keeping the number of retirement accounts you have to a minimum makes it easier to keep track of and invest your money, and you may be ready to cut ties with your former employer.
New 401(k) vs. IRA
Which is better — a new 401(k) or an IRA — depends on your particular needs. If you don’t have an IRA and intend to participate in your new employer’s 401(k) anyway, rolling over your account into the new 401(k) is the more streamlined option because you’ll have only one account to keep track of.
But an IRA offers an important advantage: It provides you with more flexibility. If you want to own a specific mutual fund or security in your retirement account, you can find an IRA custodian that will allow you to do so.
Unlike an IRA, a 401(k) limits you to the options your employer chooses to make available to you. Some plans offer a broadly diversified collection of strong-performing funds. Others are limited to only a few funds with middling track records of performance. If you’re not sure about the quality of the investments offered by your new plan, your financial advisor can help you evaluate it.
Of course, IRAs have their downsides as well. For one, they typically charge investors modest administrative fees, while employers typically pick up the costs involved with a 401(k) plan — though more employers are starting to pass some fees along to employees. Also, IRAs can’t allow loans, while 401(k) plans can (and some do). On the other hand, IRAs offer more opportunities for penalty-free withdrawals before age 59 ½ under certain circumstances.
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How to Roll Over your 401k
Whether you decide to roll over your account into your new employer’s 401(k) or an IRA, a “direct” rollover is almost always best.
Under this method, you never take formal possession of your funds. The administrator of your old 401(k) plan transfers your assets directly to your new 401(k) administrator or IRA custodian. In some cases, the check will first be sent to you to hand over to your new administrator. As long as the check isn’t made out to you personally, this is still considered a direct rollover.
By contrast, an “indirect” rollover entails you taking personal possession of your assets before ultimately rolling them over. In this case, if you don’t redeposit the funds in your new employer’s 401(k) or your IRA within 60 days, it’s considered a distribution, and you’ll owe income taxes and, generally, an additional 10% early withdrawal penalty if you haven’t reached the age of 59 1/2.
What’s more, your old employer will be required to withhold 20% of the distributed amount for federal income taxes, even if you’re doing a tax-free rollover within the 60-day time limit. If you wind up having withholding, don’t forget to replace this amount when you roll over the funds within 60 days to avoid additional taxes and penalties. You can then receive a refund for the withholding when you file your tax return.
Why Not to Cash Out
There may be a few instances when you need to consider cashing out your 401(k) instead of rolling it over. A dire medical or financial emergency could warrant such a move. But cashing out should be avoided if at all possible.
For starters, tapping your retirement funds too early accelerates tax liability and can subject you to stiff penalties. You’ll owe federal income taxes — and, depending on where you live, maybe state and local income taxes as well — on the withdrawal, as well as an additional federal penalty of 10% if you’re younger than age 59 ½ and don’t meet any of the exceptions. (One key exception: If you’re older than age 55 when you leave your job, you may be exempt from this penalty. Ask your tax advisor.)
Moreover, your employer also is generally required to withhold 20% of your distribution as a down payment on your federal income tax bill. In addition, by withdrawing funds you’ll not only reduce the size of your nest egg, but also lose its tax-deferred growth potential. The combined effect of significant taxes and penalties and lost appreciation potential going forward can be enormous.
Your New Present
When moving on to greener pastures, it’s easy to lose sight of things. But your 401(k) probably shouldn’t be one of them. As you settle into your new present, be sure to spend a little time thinking about your future retirement.
Can I Do Nothing?
Let’s say that, in the hustle and bustle, to settle into a new job, you do forget to roll over your 401(k). And when you finally get around to thinking about that old account, you just can’t summon the energy to do anything with it. Can you do nothing? Yes — as long as your account has at least $5,000 in it, by law you can’t be forced out of the plan.
There may even be some good reasons to leave your account where it is. For instance, your old plan may offer a particularly good lineup of investment choices, and mutual fund fees may be less than you could do on your own. Or perhaps your new employer’s plan is significantly inferior to your current one, or restricts eligibility for participation to employees with at least one year of service.
It’s important to know the option to leave your 401(k) behind does exist. Just bear in mind that, more often than not, you’re probably better off rolling over your retirement funds — or at least strongly considering it.
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