When you leave your employer, you may need to decide what to do with the money you have accumulated in your employer’s 401(k) plan. For some investors, this can represent a sizeable investment. As a result, it is crucial to make an informed decision.
There are several options available to you:
For most investors, this can be the least favorable option. Taking a distribution in cash can have very serious tax consequences. Your previous employer is required to withhold 20 percent for federal taxes. The cash that you receive will be taxed as ordinary income. The 20 percent that is withheld will be used to pay the taxes you owe for your federal taxes. However, depending on your tax bracket, you may owe more than the 20 percent that was withheld when you do your taxes for that year. In addition, you are likely to be penalized 10 percent if you are younger than age 59-1/2. As you can see, this could be a major setback towards saving for your retirement.
For many investors who are saving for their retirement, this may be a better decision than Option 1 since you will not be penalized or taxed. However, there are some disadvantages. Many investors find it difficult to manage and organize their retirement accounts when they have several retirement plans at previous employers. As a result, investment performance can suffer if retirement accounts are not diversified* (varied) properly. An even more important issue is that employers’ retirement plans typically have a limited number of investments available. Given that not all plans are the same, you should check on what investment options are available and if they are diverse. Also, check the expense ratio and compare it to IRA rollover options.
Most employers allow you to do a transfer into their retirement plan. Compared to Option 2, this avoids the potential problem of multiple retirement accounts at different employers and the difficulties of managing your investments and organizing them properly. As in Option 2, the same important issue still applies: most employer-sponsored retirement plans typically have a limited number of investment choices.
For many investors a 401(k) rollover into an IRA may be the best option for the money they have saved in their previous employer’s retirement plan. Compared to Options 1-3, you can have several advantages: increased control, greater organization, improved investment flexibility and investment advice. One disadvantage with IRAs is that they do not permit loans, so if your former employer’s plan permits loans to former employees, you would be giving up that option.
*There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio or that diversification among asset classes will reduce risk.
The options on this page are for informational purposes only and do not constitute, and should not be construed as, professional, legal, or tax advice. To determine your individual tax situation and specific needs, please consult a professional tax advisor.
Information contained in this section merely highlights some benefits. There are risks involved with all investments that could include tax penalties and risk/loss of principal.