Leaving Job with 401(k)? Never Cash Out

Last Updated Jul 27, 2011 12:12 PM EDT

A few days ago I wrote about what happens when a workers 401(k) account is automatically enrolled into one of the qualified default investment alternatives in the plan. Folks need to need to know that these are not personalized for your specific situation or investment objectives and making changes to your mix of investment funds can pay off with higher returns.
But one of the biggest weaknesses of 401(k) plans is that they allow workers to cash out when they leave their employer or change jobs.

Nearly half of all workers cash out their 401(k) savings when they change jobs even though they had to pay personal income tax and a ten percent penalty for early withdrawal. Most of the workers who do cash out are younger workers with smaller balances. I suppose these folks figure it's a small amount of money that it's not worth the trouble to try and save it.

But over time, cashing out even small balances can have a significant impact on ultimate retirement accumulations. Workers are likely to change jobs five to seven times before they settle into a long-term job, and if they do this every two years, they could be cashing out their retirement savings with nothing to show for it over ten to 14 years.

The best option available in many plans is to transfer their 401(k) plan account from their previous employers plan into their new employer's 401(k) plan. This of course assumes that the new employer's 401(k) plan is as good or better than the previous plan. If your new employers 401(k) plan does not permit plan-to-plan transfers, then consider either leaving the balance in the previous plan or roll it over to an IRA. Either way, you can continue to invest and grow your retirement savings.

How to Preserve Retirement Assets:
Anyone who has participated in a 401(k) plan and changed jobs has confronted the question of what to do with their account. The most common practice (second of course to cash payments) is to direct a distribution from the plan to a rollover IRA. These are the basic steps to doing this and avoiding taxes:

  • Open a Rollover IRA with a brokerage or Mutual Fund company
  • Instruct your prior plans administrator to make the distribution payable directly to your new Rollover IRA, as custodian for your benefit.
  • Do not elect to have any taxes withheld from the distribution as it will be tax-free.
  • If your plan will only send a check to your address, include your new IRA number on the check and forward it to your rollover IRA within 60 days of receipt, which is typically the post mark date on the envelop in which the check was mailed.
  • Contributions that were previously taxed cannot be rolled over. Consider investing those amounts in a Roth IRA or with your taxable savings.
Today's worker needs a 401k and a Rollover IRA if they want to have a fighting chance at preserving and building their retirement assets. Chose an IRA provider carefully making sure that they provide the investment flexibility and access you need today and as your balance grows in the future.

To be sure, rolling a retirement balance is the only option to avoid the tax drain when your balance is automatically forced out of the plan. But if your balance is above the $5,000 limit, you cannot be forced out of a prior employers plan so consider leaving it in the plan as it may have several advantages:

  • Lower investment fund fees
  • Investments that are not otherwise available in other accounts
  • Access to on-line tools and advisory services
  • Assets remaining in a Plan are exempt from creditors
Also, spouses are legally entitled to a portion of benefits accrued under an employer's retirement plan. They must consent in writing to allow amounts to be rolled over. Their rights to assets in IRAs are less protected.

Another option is to transfer your balance from a prior plan into your new employer's plan, if this is permitted under the new plans rules. An advantage is that the new plan may offer features such as investment options or loans that are not available under the prior plan or in an IRA.

For pension and retirement income payments it may be best to take the money and run, but that's rarely the case with 401(k) money.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.