Changing
Jobs? Don’t Forget Your 401(k)
Misstep
Can Cost You Thousands In Extra Taxes, Penalties
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.
Let’s
say you put in five years at your current job. For most of those years, you’ve
had the company take a set percentage of your pre-tax salary for your 401(k)
plan. Now that you’re leaving, what should you do?
The
first rule of thumb is, it’s wisest not to touch the money.
“I
think the worst thing employees can do when they leave their employer is to
withdraw money from their 401(k) plans and then keep it,” said Steve Advocat,
manager of the education and guidance department for American Century. “There
are tremendous taxes and penalties in doing that.”
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, you’re already down to $80,000.
And
if you’re not yet 59 1/2, you’ll get a 10% penalty slapped on for early
withdrawal. So now you’re down another 10% from the top line, to $70,000.
Then
at the end of the year, you’ll have to pay the difference between your tax
bracket and the 20% already taken out. That’s because distributions are taxed
as ordinary income. For instance, if you’re in the 33% tax bracket, you’ll
still owe 13%, or $13,000. Now your cash distribution is worth $57,000.
That’s
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.
What’s
more, if you decide after 60 days to roll over your remaining balance, the
government won’t let you.
When
you cash out, you take that hit (from penalties) and you short–change your
retirement savings.
Let’s Look At The Alternatives
Before you touch your 401(k), find out if
you new job offers a retirement plan. It’s 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 employer’s 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.
Don’t Panic
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
don’t panic. You have 60 days to roll over the lump sum (including the 20%) to
your new employer’s plan or into a rollover individual retirement account.
Then you won’t owe the additional taxes or the 10% early withdrawal penalty.
If
you’re not happy with the fund choices your new employer offers, you might opt
for a rollover IRA instead of your company’s 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
employer’s 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 won’t let you stay
and your new job doesn’t have a 401(k), your best bet is to do a direct
rollover into an IRA.
Perhaps
you’ve decided to work for yourself or prefer to manage your money yourself.
If so, you could roll over your distribution into an IRA. You’ll 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.” Said Jan Holman, vice president of
investment services for American Express Financial Advisors. “So it’s easy
as asking the question.”
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
don’t 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