You have four basic options, each with its own pros and cons, as well as rules you must adhere to if you don’t want to get stuck with a big tax bill and financial penalty.
Assuming your current employer allows it — not all do — you may decide to leave your 401(k) right where it is.
If the plan has top-notch, low-cost investment options, this might not be a bad choice.
Know that when leaving money behind in a 401(k), there may be restrictions on whether you can take a loan against that account or on the size of any pre-retirement withdrawals you might make — so check the rules of the plan before making your final decision.
The decision to stay with your current plan, however, might not be yours to make if your balance is below $5,000. A majority of workplace plans will require that you transfer the balance elsewhere or cash it out, according to the most recent survey of workplace retirement plans by the Plan Sponsor Council of America.
If your balance is over $5,000 but your current plan doesn’t have great, low-cost investments, you might be better off transferring the money to another tax-advantaged retirement account (more on that below).
The same is true if you already have several other existing retirement accounts at old employers.
“A really bad outcome is to have lots of little accounts scattered around. It’s easy to forget about them. It doesn’t let you appreciate how much you’ve really saved. And the odds of screwing something up gets higher,” 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 may transfer your old 401(k) savings into your new 401(k) plan.
In Lester’s view, “rolling your old account into your new employer’s 401(k) plan should be your default unless there’s a good reason not to.”
But you’ll only want to do that if the new plan offers solid, low-cost investments — or at the very least, low-cost target date funds.
The benefit of consolidating your retirement savings into one employer-sponsored plan is that it will be easier for you to track and manage the money.
Plus it will reinforce for you the amount of wealth you’re building and encourage you to keep going. In other words, it’s better to have one account with $125,000 in it than five separate accounts with $25,000 each. “Our brain can play tricks on us,” Lester said.
By the time you hit 72 you will have to start taking required minimum distributions from the 401(k), unless you’re still working at the company, in which case you may be allowed to delay doing so until you retire.
Be sure to instruct the custodian of your old plan to transfer your savings via “direct rollover.” That means the money will be sent directly from your old plan to your new one.
If you don’t do that, your old plan will send a check directly to you when it closes out your account. Then it will be up to you to make the deposit into your new 401(k), but that can be an expensive, confusing hassle you’ll 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 of your withdrawal to redeposit 100% of your money from the old plan into your new one for it to be treated as a tax-free distribution.
Say you’re transferring $10,000. You will get a check for just $8,000 because your employer must withhold $2,000 (20%) for taxes. Then, within 60 days, you must deposit the $8,000 plus come up with another $2,000 to ensure all of your original savings make it into your new 401(k) plan tax-free.
You will be able to recover the original $2,000 your former employer withheld by way of a tax refund when you file your taxes for that year, said Mark Luscombe, principal analyst at Wolters Kluwer Tax & Accounting.
If you can’t come up with $2,000 within the 60-day period, that money your former employer is withholding will be treated as a taxable distribution from your plan subject to the 10% early withdrawal penalty if you are under age 59-1/2.
In other words, you’ll not only lose out on tax-deferred growth in your new retirement plan for that $2,000, you’ll pocket substantially less than that amount because you’ll have to pay taxes and penalties on it.
Roll the money into an IRA
401(k) participants who leave their jobs also may opt to roll their savings into a new or existing IRA.
An IRA will offer you more freedom to invest as you wish. But unless you’re paying a financial adviser to manage it for you, make sure you have the time, energy and discipline to stay on top of it. And make sure the fees associated with the account aren’t excessive relative to keeping your money in a 401(k).
If you’re under 59-1/2, your IRA will offer more flexibility to make limited penalty-free withdrawals for home purchases or higher education costs.
But once you’re 72, you will need to start taking required minimum withdrawals every year, even if you’re still working.
Though it may be tempting, the worst of your four options is to cash out your 401(k) savings.
“Cashing out is almost always a bad idea,” Lester said.
The only time it might not be is if you’re in dire financial straits, she noted. “It’s better to cash out instead of declaring bankruptcy or losing your house. But that’s the level of really bad things happening to you [that we’re talking about].”
Anything less than that and you’ll hurt your financial security in retirement for three reasons:
- You will lose out both on the investment growth potential and the tax deferral that would further power that growth.
- You will owe taxes on the amount cashed out
- And if you cash out before age 59-1/2 in most instances you will also owe a 10% early withdrawal penalty. (The exception: If you’re 55 or older when you leave your job. Then you’re allowed to make penalty-free withdrawals. But you’ll still be hit with the tax bill.)
Your initial financial hit will depend on your tax bracket. Say you’re cashing out $50,000. You could pay $20,500 in taxes and penalties, according to calculations from Fidelity Investments. That assumes you’re in the 24% federal tax bracket, a 7% state tax bracket, and you’re subject to the 10% early withdrawal penalty.
In other words, nearly half your money would be gone before you’re even close to retiring.