It might seem like a pain in the neck to sock away a percentage of each paycheck in an employer-sponsored investment plan. But for many Americans, the 401(k) is the retirement device of choice, because it’s usually the simplest and most accessible option.
Besides, the 401(k) is a total workhorse: Its high contribution limits and income tax benefits make it a powerful financial tool, and it might even be a source of free money (an elusive phrase, at best) if your company offers an employer match.
These days, though, it’s hard to find a retiree with only one lifelong employer. Most of us work for several different businesses over the course of our careers. So what do you do with your old job’s 401(k) funds when you’re gearing up for your next chapter?
Whether you’re headed to a new company or striking out on your own, you have several options when it comes to bringing your hard-earned (and hard-saved) 401(k) dollars with you.
Cashing in (spoiler alert: don’t do this)
The first option — and the worst — is to cash in the account. Yes, a potentially significant windfall can seem like an attractive option, especially during a transitionary period. But because 401(k) contributions are made before income tax is assessed (unless you have a Roth 401(k)), you’ll be handing a significant chunk of that check directly over to Uncle Sam — not to mention the 10% early-withdrawal penalty if you’re not yet 59 1/2 years old.
Plus, you want to keep that money invested so the power of compound interest can leave you sitting pretty later on. So let’s move on to our other options.
Sometimes called a custodian-to-custodian transfer, a direct rollover is the ideal way to move your 401(k) funds. The cash stays invested, but the account moves to new management (i.e., your next employer). And since you never actually touch the money yourself, you won’t have to pay any taxes on it.
But there is one important caveat: Not all types of retirement plans are eligible to be directly rolled over into all others. And if your next gig doesn’t come with a 401(k), you may have to finagle a different option.
The IRS offers a handy rollover chart to help you figure out which types of accounts are compatible. The good news: A traditional 401(k) can be rolled over into almost any other retirement account — though, depending on the target account type, there may be some qualifiers and stipulations. And if your 401(k) is a Roth type, you’ll have to move it into another Roth account, be it an IRA or another employee-sponsored plan.
Another option is the indirect rollover, wherein your employer cashes out the account and hands you a check, which you then manually reinvest. But this approach has some tax-related complications.
Since your 401(k) is funded with pre-tax contributions, the account administrator is required by the IRS to withhold 20% of the total to cover taxes. That means you’ll be getting a check for only 80% of your account total — and, again, if you’re under age 59 1/2, you’ll also be assessed a 10% penalty.
You can avoid all those charges by reinvesting the money into a new retirement account within 60 days. But you’ll have to reinvest the original account total, which means pulling some funds from your own pocket to make up the difference. (You later get the difference back in the form of a tax credit.)
Our best advice: If you can’t roll the funds directly into a new 401(k), open an IRA and keep letting the cash grow. Even if you get another employer-sponsored plan later on, it never hurts to have more than one retirement account at your disposal.
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