Best 401(k) Moves When You Leave a Job

Nearly half of employees cash out their 401(k) balance when they move to a new job, according to a survey by Hewitt Associates. That’s a whopper of a goof. Not only will you pay taxes on all that cash (plus a 10 percent early-withdrawal penalty if you’re under 55 — ouch!), you’ll lose out on the future compounding and growth from leaving it in a 401(k) or by rolling it into an IRA.

For instance, say you cash out a $200,000 401(k) at 45 and you’re in the 28 percent tax bracket. After paying $56,000 to taxes and $20,000 in penalties, you will have managed to whack your nest egg down to $124,000, or the equivalent of a pretty brutal bear market. Had you left the money in the account or in a rollover IRA instead, and let it grow at 7 percent a year until you hit 65, you would have had nearly $774,000. Given that you are unlikely to have a pension, Social Security is looking a little shaky, and the actuarial tables say you will live longer than any previous generation, sabotaging your retirement savings is a really bad idea. Even if you have a change of heart and invest that $124,000, you’d have just $480,000 at retirement, assuming the same 7 percent return. Even after paying taxes on the eventual withdrawals, you’d still come out ahead in the first scenario.

“It’s a bird-in-the-hand sort of mentality,” says Jay Hutchins, a financial planner in Lebanon, N.H. “That money is going to be of use so far in the future that a lot of people don’t perceive it as having any value today. It’s a big mistake, but an understandable one.”

It’s alluring to just keep your 401(k) cash where it’s been when you pack it in. After all, the plan was good enough for you while you worked there, right? Actually, leaving well enough alone is often unwise. “A lot of people don’t realize that 401(k) plans are just riddled with fees,” says Annapolis financial planner Ted Toal. “People can be paying 2 to 3 percent annually just to have their money sit there.” Not only that, but your future investment options will be limited to whatever’s offered in the plan.

Ask your plan administrator for a rundown of the 401(k) fees. If they’re comparable to what you’d find in a low-cost rollover IRA — usually just the funds’ expense ratios — and you’re happy with your investment selection, then feel free to stay put. But don’t forget about this money. “Sometimes people never go back and rebalance the portfolio or evaluate the funds that they’re in,” says Chip Addis, a financial planner in Wayne, Pa. Not to mention that your old company may not be around forever. It’s still your money, but who needs the hassle of tracking down the account?

In most cases, a rollover IRA is a better option than leaving the money in your old 401(k) or transferring it to your new employer’s plan. Fees are typically lower and you’ll have more investment options. There are also more ways to avoid a withdrawal penalty for taking money out of an IRA compared with a 401(k). “You can withdraw money without penalty as a first-time home buyer, for higher education, and for health insurance while you’re unemployed,” says Houston financial planner Gary Busch. With a 401(k), you can make withdrawals only after proving financial hardship; the money must be for certain purposes, such as buying a home or paying college tuition and you’ll owe taxes on the withdrawal plus a 10 percent penalty.

If you think you might want to deposit your 401(k) money into a new employer’s 401(k) someday, don’t move the cash into an IRA you already have. If you do, you won’t be allowed to transfer the money later. Instead, open a new rollover IRA, ideally with a discount brokerage, and invest in no-load, low-cost index funds such as ones offered by Vanguard, Fidelity, or Schwab.

One important caveat that applies in the coming year: You may not want to roll over your 401(k) into an IRA if you plan to convert any of your IRAs into a Roth IRA next year, when the conversion rules get liberalized. In 2010, anyone can convert a traditional IRA to a Roth. Normally, high-earners cannot contribute to a Roth; in 2009, the cutoff for couples is an adjusted gross income of $169,000 or above. (With a Roth IRA, contributions are taxed and withdrawals are tax-free.) Otherwise, you may face an unnecessary tax bill.

Here’s why: The IRS views all your traditional IRA accounts as one big bucket, from a tax standpoint. Say you already have $50,000 in a nondeductible IRA — $40,000 from post-tax contributions and $10,000 from earnings. Convert that $50,000 to a Roth next year and you’d only owe taxes on 20 percent of it — the $10,000 in earnings. But move a $50,000 401(k) into a rollover IRA and the IRS will view the two IRAs as one totaling $100,000 — $50,000 pre-tax (from the company plan), $40,000 post-tax, and $10,000 in taxable earnings. Then, a Roth IRA conversion will be prorated accordingly for tax purposes. So if you roll the $50,000 nondeductible IRA into a Roth, the IRS will now view that money as $25,000 pre-tax, $20,000 post-tax, and $5,000 in taxable earnings. End result: You’ll owe taxes on $30,000 instead of the $10,000 if you hadn’t done the 401(k) rollover.

“Keep your 401(k) money out of an IRA if you don’t want to pollute the rest of your IRAs,” says Chris Long, a Chicago financial planner.

Another reason to consider rolling your 401(k) into a Roth IRA: You think your tax rate will be higher in the future and want your distributions to escape those taxes. Just be prepared to come up with additional cash now to pay the taxes due at conversion, since the 401(k) money will be considered a taxable distribution. If you roll over that same $200,000 401(k) into a Roth IRA and you’re in the 28 percent bracket, for example, you’ll need to find an additional $56,000 to cover your tax bill. The good news: The IRS is allowing taxpayers two years (2011 and 2012) to pay the tab, if you need it.

There’s a little-known way to save on your tax bill if you hold company stock in your 401(k). Normally, if you roll over your company stock into an IRA, you’ll owe steep ordinary income taxes on the money when you eventually withdraw it in retirement (just as you will on all investments in the account). If you instead take a payout of the company stock now, you’ll owe income taxes (and any early withdrawal penalty) on just your original purchase price of the stock, but you’ll pay the lower capital gains tax rate — 15 percent — on the appreciation. This strategy is called Net Unrealized Appreciation or NUA — the difference between your original price, or cost basis, and the market price.

It’s probably not worth it unless the company stock has zoomed higher, increasing the share of your holdings that are capital gains. You may want to consult a financial planner to see whether it’s right for you, or use the Net Unrealized Appreciation (NUA) vs. IRA Rollover calculator at CalcXML.com. Caveat: If your company didn’t keep track of the shares’ cost basis (and some don’t), you’re out of luck.

If you plan to roll your 401(k) into an IRA or your new employer’s plan, make sure you do a trustee-to-trustee transfer. That is, the check should be made out to your new plan, not to you. If the employer you’re leaving insists on sending you a check, tell the benefits administrator to make it out to the IRA’s investment firm or your new employer’s 401(k) plan. Otherwise, your ex-employer will withhold 20 percent for taxes, and you’ll be in the same unpleasant position as if you had cashed out (see Rule 1). Big discount brokerages are eager to get 401(k) rollovers, so working with one should make your transfer pretty simple.

Maybe you haven’t had enough time to throw serious money into your 401(k). At some firms, if your balance is $5,000 or less when you leave, the company will automatically distribute the money to you — minus the 20 percent it’s obligated to withhold for the IRS. Then if you don’t want to take the money as a taxable distribution, you must roll it over into your new employer’s 401(k) or an IRA within 60 days and — get this — come up with the missing 20 percent yourself. So if your 401(k) was worth $4,500, you’d get a $3,600 check but would need to add $900 to the rollover or face IRS tax penalties. Ask your plan administrator for the firm’s policy on 401(k) balances, and be prepared to roll over your small balance before they send you a check.

More on MoneyWatch:

• 12 Dumbest 401(k) Mistakes
• What to Do With Your 401(k) Now
• How Good Is Your Company’s 401(k) Plan?
• Solo 401(k)s for Self Employed
• Don’t Tap into Your 401(k)?
• Retirement Report Card: Are You Saving Enough?