The 401(k) is, without any reservations, the best hope for every middle class American to build up a nest egg for life after retirement. It’s a qualified retirement plan with tax deferred growth matching contributions from employers. With the job market in a constant state of flux, more and more employees are forced to switch jobs or quit and start hunting for a new one.
What should you do about the 401(k) funds accumulated with an employer you no longer work for? Your options include leaving the money to grow in the plan, rollover the 401(k) funds into an IRA or your next employer’s 401(k) plan, or simply pay the taxes and withdraw the money. Which option you opt for depends upon whether you need the money, your investment requirements, tax considerations associated with the transaction and of course, your next job and the 401(k) plan offered by your next employer, if any.
The first impulse is to withdraw the money and spend it on short term needs. This is mainly due to the fact that you suddenly have access to funds which otherwise would not have been available for years, if not decades. While understandable, this impulse is likely to end up as a costly transaction. First you get hit with early withdrawal taxes. Second, early withdrawal penalties of up to 10% would likely be imposed by the IRS. Lastly, you will have to start all over again to build up a retirement fund. An exception to this rule would be if your employer has made contributions to your plan in the form of company stock or you have yourself added contributions in the form of company stock, which has appreciated significantly since being allocated to you. The IRS will tax only the original value of the stock, instead of the appreciated value, when you withdraw the stock from the 401(k) and move it into a regular investment plan. The rest is charged as capital gains as per the rules of the new investment plan.
The second option is to rollover 401(k) funds into an IRA or your next employer’s 401(k) plan. Both options have significant benefits when compared to the simple withdrawal or leaving the money as it is. For starters, there is a specific product called a rollover IRA, which has been designed to hold funds in between transfers from one 401(k) to another, without being hit with penalties, withdrawal or transfer charges.
The IRS offers a holding, or limbo, period of 60 days while you make the decision of what to do with the 401(k) funds in an ex-employer’s plan. By making use of a rollover IRA, you can increase this holding period indefinitely. Even if you yourself do nothing about the money, your ex-employer is likely required to transfer the funds into an IRA on your behalf. An IRA offers greater flexibility in terms of investment options, use of funds and consolidation of funds from various sources of income. On the other hand, a 401(k) plan relives you of the responsibility of making investment decisions, and some employer group plans offer investment discounts and higher rate of returns on account of the volume transactions involved. There is also the very important question of maximum contributions, and if you are planning to max out contributions to the 401(k) plan offered by your new employer, it might make sense to leave the earlier funds in an IRA and make additional contributions to it separately.
The best option, for the ordinary investor, is to do a 401(k) rollover into a new employer’s plan. This offers continuity and accumulation of funds within a single account, and you are completely aware of any changes to the company’s plans, investment policies and other factors which may affect the performance and growth of your plan. Leaving the funds with an ex-employer deprives you of that awareness, and you may end up losing a significant amount by not being aware of major changes to the plan by your former employer. You should always have an IRA available, in case you quit or lose your job, which enables you to rollover the 401(k) funds until such time as you have access to a new employer sponsored qualified retirement plan.
Please note that a decision with regard to a 401(k) rollover is a highly personal decision, based on your specific situation. Secondly, even if you do not have to pay withdrawal or transfer charges for doing a rollover, the IRS has strict guidelines defining a rollover. For example, you can directly transfer the funds from your 401(k) to an IRA, without receiving a check. Or, you can receive a check and then fund a rollover IRA with the same amount, within 60 days. A study of what constitutes a 401(k) rollover rather than a withdrawal is advisable, along with the costs and tax benefits associated with each option open to you.