You have an important decision to make when you retire. What to do with your former employer’s 401(k)? There are just a few things you can do with the money. Each option provides different benefits and each has different consequences. Here’s a look at what your options are and why they matter.
What you can do With Your Former Employer’s 401(k)
At retirement, you can pull the cash out of the plan. You can roll it over directly into a new or existing IRA. Or you can leave your money where it is.
There’s a fourth option if you leave an employer before you retire. You can transfer the money to a new employer’s plan. When you retire, this opportunity kind of goes away.
Cashing out Your 401(k)
Cashing out your 401(k) in one lump sum distribution is typically a bad idea. It becomes taxable income.
There’s no way to avoid that. In fact, your employer is required to withhold 20 percent of the distribution. And if you’re not yet 55 years old, the distribution is also generally subject to an additional 10 percent early withdrawal penalty.
Early withdrawal penalties apply to distributions taken from a retirement account before you reach age 59½. But there’s a special rule for 401(k) plans. If you reach age 55 before you leave your former employer, then distributions you take aren’t subject to the penalty.
How does all of this add up? Let’s run some numbers.
The Math of Cashing out
Let’s say your 401(k) balance is $250,000. When you take that lump sum distribution, the 20 percent withheld by your employer leaves you with just $200,000.
If you’re not yet 55, you’ll be subject to the additional 10 percent penalty on the whole $250,000. This comes to $25,000. You’ll report this when you file your next tax return. You’ll also report the whole $250,000 as income and the $50,000 withheld as a tax payment.
Oops…Mulligan
Now, let’s say you change your mind and decide to roll the proceeds over to an IRA. You have 60 days to do this.
While the whole $250,000 is eligible to go into that IRA, you have just two hundred of it. Remember, your employer withheld $50,000. So, you’ll have to find other money if you intend to roll the full balance of your old 401(k).
Assuming you don’t have a spare fifty grand lying around, the amount you’ll roll over is $200,000. Here’s what this looks like come tax season.
The $200,000 is a nontaxable rollover. You’ll report the $50,000 your employer withheld as income. But that “income” was used to pay taxes. So, you get to report it as a tax payment. And if you’re under 55 years old, you still have to report the early withdrawal penalty, which is 10 percent of the $50,000.
So, taking a lump sum distribution form an old 401(k) can be expensive. You’ll be subject to withholding, a possible penalty, and you’ll lose the tax-deferred compounding those amounts would have provided. All of this is why there are accountants, and why you should consult one before taking a lump sum distribution from your 401(k).
But there are also consequences of a direct rollover.
Direct Rollover Into an IRA
Most retirement plans allow you to roll your money directly into an IRA. Doing this could open up a whole universe of investment opportunities that aren’t available in your old 401(k).
But fees and expenses could be an issue.
Economies of scale may make your former employer’s 401(k) less expensive than an IRA. So, you’ll need to do some research and compare current fees to expected ones in a transferred account.
From a tax perspective, there are reporting requirements, but a direct rollover doesn’t create any taxable income or penalties. And (using the previous example’s numbers) your entire $250,000 balance can continue to enjoy tax-deferred compounding.
Leave The Money Where it is
If your former employer’s 401(k) delivers acceptable investment performance, you might consider leaving the money there, especially if its investment options aren’t available outside the plan.
Cost is another consideration. Compare fees and expenses before making a move (or staying put).
In the long run, there is no right or wrong answer about what you should do with your old 401(k). The decision has to fit your unique financial circumstances.
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If you have other questions, call one of our Investment Specialists at (800) 235-8396.
