You have four basic options, each with their own pros and cons, as well as rules you need to follow if you don’t want to end up with a big tax bill and a financial penalty.
Assuming your current employer allows it – not all of them – you may decide to leave your 401 (k) where it is.
If the plan offers top-notch, low-cost investment options, it might not be a bad choice.
Be aware that when leaving money in a 401 (k) there may be restrictions on whether you can take a loan out of that account or on the amount of pre-retirement withdrawals you could make – so check. the rules of the plan before making your final decision.
However, the decision to stay with your current plan may not be up to you if your balance is below $ 5,000. The majority of work plans require you to transfer the balance elsewhere or cash it in, according to the most recent workplace pension plan survey conducted by the Plan Sponsor Council of America.
If your balance is over $ 5,000 but your current plan doesn’t have attractive, low-cost investments, you may be better off transferring the money to another tax-efficient retirement account (more details below). below).
The same is true if you already have several other existing retirement accounts with former employers.
“A really bad result is having a lot of little accounts scattered around. It’s easy to forget about them. It doesn’t allow you to appreciate how much you’ve really saved. And the chances of missing something increase,” said Anne Lester. , the former head of retirement solutions at JP Morgan Asset Management who founded the Aspen Leadership Forum on Retirement Savings in partnership with AARP.
Transfer the money to your new employer’s 401 (k)
If your new employer’s plan allows it, you can transfer your old 401 (k) savings to your new 401 (k) plan.
In Lester’s opinion, “upgrading your old account to your new employer’s 401 (k) plan should be your default option, unless there is a good reason not to.”
But you’ll only want to do this if the new plan offers solid, low-cost investments – or at the very least, low-cost target date funds.
The advantage of consolidating your retirement savings into one employer-sponsored plan is that it will be easier for you to track and manage the money.
In addition, it will strengthen for you the amount of wealth you are building and encourage you to keep going. In other words, it is better to have one account with $ 125,000 than five separate accounts with $ 25,000 each. “Our brains can play tricks on us,” Lester said.
By the time you turn 72, you will need to start collecting the required minimum distributions from 401 (k), unless you are still working at the company, in which case you may be allowed to delay payment until you retire. .
Be sure to ask the custodian of your old plan to transfer your savings through “direct renewal”. This means that the money will be sent directly from your old plan to your new one.
If you don’t, your old plan will send you a check directly when you close your account. Then it will be up to you to make the deposit into your new 401 (k), but it can be a costly and confusing hassle that you will want to avoid.
Here’s why: First, your employer will be required to withhold 20% of the money for taxes and you only have 60 days from the day you withdraw to re-file 100% of your old plan money into your new one to be treated as a tax-free distribution.
Let’s say you transfer $ 10,000. You will only receive a check for $ 8,000 because your employer has to withhold $ 2,000 (20%) for taxes. Then within 60 days you must deposit the $ 8,000 plus an additional $ 2,000 to make sure all of your original savings end up in your new 401 (k) tax-free plan.
You will be able to recover the original $ 2,000 withheld by your former employer through a tax refund when you file your taxes for this year, said Mark Luscombe, senior analyst at Wolters Kluwer Tax & Accounting.
If you fail to get $ 2,000 within the 60 day period, this money your former employer withholds will be treated as a taxable distribution from your plan subject to the 10% early withdrawal penalty if you are under 59 / 1 /. 2.
In other words, you will not only lose the tax-deferred growth of your new pension plan for that $ 2,000, but you will pocket considerably less than that amount because you will have to pay taxes and penalties.
Roll the money into an IRA
401 (k) participants who leave their jobs can also choose to transfer their savings to a new or existing IRA.
An IRA will give you more freedom to invest the way you want. But unless you’re paying a financial advisor to handle it for you, make sure you have the time, energy, and discipline to stay on top. And make sure the fees associated with the account aren’t excessive compared to keeping your money in a 401 (k).
If you’re under 59 and a half, your IRA will give you more flexibility to make limited withdrawals without penalty for buying a home or paying for graduate school.
But once you turn 72, you’ll need to start making the minimum required withdrawals each year, even if you’re still working.
While it may be tempting, the worst of your four options is to cash in your 401 (k) savings.
“Cashing in is almost always a bad idea,” Lester said.
The only time you might not be is if you are in dire financial straits, she noted. “It’s better to cash in than to file for bankruptcy or lose your house. But that’s the level of very bad things happening to you. [that we’re talking about]. “
Anything less and you will hurt your financial security in retirement for three reasons:
- You will lose both the growth potential of the investment and the tax deferral that would further fuel that growth.
- You will owe taxes on the amount collected
- And if you make a withdrawal before the age of 59.5, in most cases you will also have to pay a 10% early withdrawal penalty. (The exception: if you are 55 or older when you quit your job. You are then allowed to make withdrawals without penalty. But you will still have to pay the tax bill.)
Your first financial hit will depend on your tax bracket. Let’s say you cash out $ 50,000. You could pay $ 20,500 in taxes and penalties, as calculated by Fidelity Investments. This assumes that you are in the 24% federal tax bracket, 7% state tax bracket, and that you are subject to the 10% early withdrawal penalty.
In other words, almost half of your money would be gone before you were even about to retire.