When you leave your job, either voluntarily or not, you have to make an important decision regarding your 401(k).
Many aren’t familiar with all their options on what they can do with their 401(k), but making the wrong choice could cost you. Most people are familiar with the 401(k) rollover concept but still need some help through the process.
Here are your options if you are faced with this decision.
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Cashing Out Is Not the Best Option
Whatever money you put in yourself, you can cash out and take it with you. If your employer has a match, you may be subject to some sort of vesting schedule. Many people choose to cash out their 401k’s.
The most common reasoning here, especially for 401k plans that have matching, is that it’s “The company’s money” not “theirs“. Wow! Isn’t that great reasoning?
By taking “The company’s money”, that person is stuck with a 10% early withdrawal penalty plus ordinary income tax. Typically, when you cash directly from your 401k they will hold a 20% standard plus the 10% early withdrawal penalty.
Leave Your 401k Alone
You always have the option to just leave the money with your old plan. The money will remain invested, and the financial firm handling your 401(k) will keep mailing you quarterly statements telling you how it is doing. Any future growth will be tax-deferred.
But this passive choice comes with an opportunity cost. If you just leave the 401(k) assets in the plan, you’re giving up control and flexibility.
Your investment choices may be limited, the plan fees may be high, and you may not be able to quickly access your money or do what you want with it.
If you have a trail of old 401(k)s left with a bunch of former employers, things can get really complicated when you retire – especially when you have to take Required Minimum Distributions (RMDs).
Leaving the money in the plan may not be the wisest choice.
Transfer the 401k to a New Employer
Most people have the option to transfer their old 401k into their new 401k with the new employer. In the past, this used to be more difficult, but with recent government regulation changes, it’s much easier.
While this could be a good decision, a lot depends on the new options that are in the new 401k.
You Could Roll Your 401k Into an IRA
This is the choice that usually makes the most sense. You can move the money into an IRA through a rollover or trustee-to-trustee transfer.
Or, you could direct the money into a so-called “conduit IRA,” a traditional IRA created to hold your old 401(k) assets until you move the money into another qualified retirement plan.
There’s no tax penalty when you do an IRA rollover or trustee-to-trustee transfer. After you do it, you have total control of the money, continued tax-deferred growth, expanded investment choices, and possibly lower account management fees.
Rolling over the money into a Roth IRA might be a great move, provided you can meet two conditions. First, your adjusted gross income has to be less than $100,000 for the year in which you make the rollover. Second, you’ll have to pay taxes on the assets you convert.
The Upside Is Considerable:
Contributions to a Roth IRA are not tax-deductible, but there are fewer restrictions on withdrawals.
In 2009, you can fund a Roth IRA with after-tax contributions to a 401(k), 403(b), or 457 retirement savings plan – you can take those contributions and convert them to a Roth IRA tax-free, provided your AGI is $100,000 or lower.
There is no limit on the conversion amount. Incidentally, in 2010, anyone can convert a traditional IRA to a Roth IRA – the AGI restriction on such conversions disappears.
What if You Have to Shiver Through a 401(K) Freeze?
A “freeze” is when your employer reduces or suspends matching contributions to your retirement plan. FedEx, General Motors, and Motorola have all recently chosen to do this. The answer: don’t let up on your personal contributions.
If you can manage it, adjust your 401(k) contribution to a level where you effectively replace what your employer contributed. Saving for retirement should remain one of your highest priorities.
If you still need help with your 401(k) rollover, be sure to seek counsel from a Certified Financial Planner™ professional.
Bottom Line: 401(k) Rollover to IRA Options
Cashing out early incurs penalties and tax implications. Leaving your 401(k) untouched can lead to missed opportunities and complicated retirement processes.
Transferring to a new employer’s plan or rolling into an IRA offers flexibility, expanded investment options, and potential tax benefits, especially with Roth IRAs.
In the event of a 401(k) freeze, maintaining personal contributions remains paramount. For tailored guidance, consulting a Certified Financial Planner™ is advised.