Leaving a job can bring up complicated questions, and one of them is what to do with your 401(k) plan.
Some in this situation are tempted to cash out. If you do this before age 59 1/2, you will face income taxes and a 10% federal penalty. It’s an unwise move unless there are serious extenuating circumstances.
Many employers allow you to keep your 401(k) plan with the company even after you terminate employment, as long you have a certain amount in the plan. But leaving the account there means you can no longer add to it or borrow from it. Another option is to transfer the funds to a new 401(k) plan at a new employer or to roll them over to an IRA account.
401(k) transfer or IRA rollover?
If you have a choice between moving funds to a 401(k) and to an IRA, which is better? If you roll over your 401(k) to an IRA, it is likely that you have more investment options. However, the 401(k) may have some attractive investment options not available with an IRA. If you are still working, some 401(k) plans allow you to roll over some funds out of your 401(k) to an IRA and allow you to continue contributing to your 401(k). This is an option you may want to consider if there are attractive options in both. Many 401(k) plans offer a loan option, which isn’t available with an IRA. You should only use this option if you know you will be able to repay the loan when you leave your position. If you do not repay the loan in full, the outstanding balance is considered a distribution and is taxable, and you would incur the 10% penalty if you haven’t reached 59 1/2.
Another factor is cost. The recurring cost associated with the 401(k) may or may not be lower than the annual costs associated with an IRA. Make sure you do a cost comparison before you make the decision to transfer funds to an IRA.
Rolling over to an IRA
If you choose to roll over your 401(k) balance to an IRA, you have two options: a direct or an indirect rollover. The best alternative is a direct transfer from the custodian of your 401(k) to the custodian of the IRA. Advantages of this method are that you can do an unlimited number of transfers in a year, and you avoid income tax liability.
In an indirect rollover, you receive the funds from the 401(k). You then have 60 days to transfer the money to an IRA custodian. This approach has some disadvantages. One is this option is only available once in any 12-month period. If you make the mistake of rolling over funds to the IRA more than once in a 12-month period, the IRS will assume it is a withdrawal, and the amount withdrawn will be taxable. And if you haven’t reached 59 1/2, there also will be a 10% penalty. The second disadvantage is that if there is any delay, for any reason, and the money has not been transferred during the 60-day period, the amount withdrawn will be taxable (along with the 10% penalty if you haven’t reached age 59 1/2). A third disadvantage is that if you don’t do a direct transfer, 20% of the funds are withheld. Although the amount withheld is still eligible for the rollover, you must replace the funds from a different source.
The bottom line: If you contribute to an 401(k), look carefully at all your options both during and after employment. Your decisions are likely to be very important for your financial well-being.
(Article written by Elliot Raphaelson)