While economists claim that the recession is officially over, seven years later there are still many people who have had to make some difficult choices about their 401(k)s. Unlike a Traditional or Roth IRA, a 401(k) retirement plan resides with your empIoyer. And if you lose your job or switch employers, there are some serious issues to consider.
Here are four things to consider about rolling over your 401(k) after losing or switching your job:
Cashing out your 401(k)
If you need the money, of course, you may not have a choice but to tap your retirement account. However, if you liquidate any money in your 401(k) account before age 59½, you will pay both ordinary income taxes as well as a 10 percent early withdrawal penalty.
The exception is if you lose your job and are 55 or older. In this case, most plans allow you to access your funds without an early withdrawal penalty. The downside is that you will still owe taxes on your withdrawal and forfeit the ability to earn tax-deferred growth on those funds.
Leaving your 401(k) with your former employer
You may think that it’s convenient to keep your retirement assets in your old company’s plan, but it can limit your investment choices over what you could do with the money in an individual IRA. Plus, if you have more than $1,000, but less than $5,000, your employer can transfer your assets into a Safe Harbor IRA with an investment company that they choose — and which may have a different selection of funds, higher fees and beneficiary restrictions than you would prefer.
And if you have less than $1,000 in your employer-sponsored 401(k) account, your ex-employer can close your account and send you a check – minus a 20 percent tax withholding.
One of the benefits to leaving your money in your 401(k) is that your funds are protected from creditors, which is not something that most states allow with individual IRAs.
Rolling your 401(k) into an IRA
If you decide to roll your 401(k) into an IRA, you are not tied into your employer’s investment options and can take greater control over what you do with your retirement savings. With an IRA, you can withdraw cash, penalty-free, for a first-time home purchase or qualified education expenses — something you can’t do with a 401(k).
You may also want to think about what type of IRA you want to direct your 401(k). With a Roth IRA, once you pay conversion taxes, your withdrawals are tax-free. The catch is that you must hold your Roth account for at least five years and are at least 59½ years old. Learn more about the difference between a 401(k) and Roth IRA.
Rolling your 401(k) into your new employer’s plan
If you quickly move into another job, you have the option to roll over your 401(k) into your new employer’s plan. There are potential obstacles to transferring your previous 401(k) to another employer’s plan, so make sure you understand the risks and rewards.
Ask for a trustee-to-trustee transfer
Any time you are rolling over your 401(k) from one account to another, you need to understand the very specific rules. It’s vital that you do not directly receive a check that you deposit directly into a checking or savings account. Instead, ask your company to send you a check for the 401(k) assets you plan to roll over for a trustee-to-trustee transfer, which is also called a direct transfer or a direct rollover.
The reason? When you are rolling over your 401(k) distribution, it must be put back into another IRA or other tax-deferred employer retirement plan within 60 days. If you miss that deadline, the IRS views it as a taxable and, depending on your age, possibly an early distribution that will be subject to penalties.
Additionally, if your 401(k) plan administrator issues you a check for your account balance, they will be required to withhold 20 percent of the balance for federal taxes. Then, when you deposit your check into your new IRA account, you’ll have to come up with that missing 20 percent. Depending on your 401(k) balance, that could be a significant sum — especially if you lost your job and are struggling with expenses.
If you invest the full amount into a tax-deferred account within 60 days, you will get the 20 percent that was withheld back after you file your tax return. However, that could be a number of months that you could have been using that money to grow your retirement account.
3 Mistakes to avoid before you leave your job
Keep in mind that the way you handle your 401(k) while still working for your employer can also make a difference. Make sure to maximize your retirement fund and avoid the following mistakes:
1. Not saving enough
Most people have an employee matching benefit up to a specific percentage that can add a good amount to their 401(k) accounts over the years — especially considering compounding interest. If you can, make sure that your contributions qualify for the employer matching. If you don’t, you’re just leaving money on the table.
2. Taking a 401(k) loan
There are situations when you must borrow from your 401(k) such as to pay for extraordinary medical expenses or a house down payment. However, most financial experts advise against taking a loan against your retirement account.
Since the job market is uncertain at best, if you borrow from your 401(k), most plan rules require that you repay the amount within 30 or 60 days of leaving your job. Like any other distribution, you may be required to pay a 10 percent penalty on top of state and federal taxes if you are under 59 ½. Even worse, if you can’t repay the loan, the IRS may take the loan from your remaining 401(k) balance.
3. Not making catch-up contributions
If you are age 50 or older you can contribute $17,500 to your 401(k) account in 2014, plus an additional $5,500. This means a total contribution of up to $23,000 each year to your retirement account.
If you change jobs and enroll in your new employer’s plan, be sure to activate the additional catch-up contributions so that you can continue to benefit from the power of the employer match and compounding interest.
Whether you lose your job or find a new one, there are smart ways to roll over your funds so you don’t lose out. Be sure to check with your former employer’s 401(k) plan administrator to determine how to best manage your 401(k) assets.