Have you recently made a job change or perhaps you have been part of a corporate reorganization or downsize? One of the most important questions you face when changing jobs is what to do with the money in your 401(k). Making the wrong move could cost you thousands of dollars or more in taxes and lower returns.
Now that you’re leaving, what should you do? The first rule of thumb is to leave it alone because you have at least 60 days to decide whether to roll it over or leave it in the account.
Resist the temptation to cash out; because in addition to a 10% penalty for early withdrawal if you’re younger than 59 ½, the plan administrator will withhold 20% of the total in your account for federal income taxes. The worst thing an employee can do when leaving a job is to withdraw the money from their 401(k) plan and put it in his or her bank account.
Also, because distributions are taxed as ordinary income, at the end of the year, you’ll have to pay the difference between your tax bracket and the 20 percent already taken out. You might also have to pay state and local taxes. Between taxes and penalties, you could end up with little over half of what you had saved up, short-changing your retirement savings significantly.
If your new job offers a retirement plan, then the easiest course of action is to roll your account into the new plan before the 60-day period ends. Referred to as a “ rollover
” it is relatively painless to do. The 401(k) plan administrator at your previous job should have all of the forms you need. Check with your new employer to see if there is a minimum period of time you need to work to be eligible for their 401K plan.
The best way to roll funds over from an old 401(k) plan to a new one is to use a direct transfer. With the direct transfer, you never receive a check, and you avoid all of the taxes and penalties mentioned above, and your savings will continue to grow tax-deferred until you retire.
If your vested account balance in your 401(k) is more than $5,000, sometimes you can leave it with your former employer’s retirement plan. Your lump sum will keep growing tax-deferred until you retire.
If you can’t leave the money in your former employer’s 401(k) and your new job doesn’t have a 401(k), your best bet is a direct rollover into an IRA. The same applies if you’ve decided to go into business for yourself.
Once you turn 59 1/2, you can begin withdrawals from your 401(k) plan or IRA without penalty and your withdrawals are 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 70 1/2, whether you’re working or not.
It’s important to take scope and plan today in order to be able to have a quality of life when you retire.