The top three questions I am asked most often these days with regard to 401(k) accounts are:
Should I leave my 401(k) in a prior employer plan while out of work?
Is it best to roll my account into a new employer plan every time I change jobs?
Can I cash my 401(k) in if I need the money now?
The main benefit of leaving 401(k) accounts at your former employer is that you don’t have to do anything. While this method is very convenient, it is not void of drawbacks. 401(k)’s typically come with a limited number of investment choices available to their participants. Leaving your accounts at former employers, may not serve you best, and can get confusing if you leave several or more accounts at various different companies.
When you do get a new job, one option would be to roll your 401(k) over into the new employer’s retirement plan, if that is an available option. Obviously, this would make keeping track of your assets easier.
Some people find this an attractive option when their employer offers employee loan provisions for 401(k) accounts. (These types of provisions allow employees to borrow against plan assets and pay the loan back via payroll deduction for return of principal and interest.) It is important to note that assets which have been lent out will be deprived of any growth on the loaned portion of the portfolio they would have received has they not taken out a loan.
Whether you leave your accounts at various employers, or bring them all to a new employer, investment options can be limited through workplace plans. Alternatively, there are numerous choices available if you opt to transfer your account into a Rollover IRA. This option gives investors the most flexibility if executed properly.
The first step in properly executing this exchange would be to assure that the account is a custodian to custodian transfer. By doing so, you eliminate the possible tax ramifications of not having the moneys properly transferred within a 60 day period as required by the IRS.
It is important to make certain that you do not comingle these funds with separately funded IRA’s you may have if you want to roll them into a new employer plan at some point in time. Comingling will render the account incapable of subsequently rolling back into a 401(k) plan; keeping the funds in a separate IRA Rollover Account will allow redeposit into a current 401(k).
Cash It In
If, and that’s a really a big ‘IF’, you really need the money before retiring, you can cash in all or part of your retirement plan. BUT, the IRS will make you pay dearly for early access. The IRS levies a 10 % penalty on anyone under age 59 ½ who cashes in all or part of their retirement plan. On top of that, you will also have to pay Federal Income Taxes on the amount withdrawn.
What most people don’t realize is how costly early withdrawal can be. For example, if a 40 year old in the 28% income tax bracket cashes in their $10,000 401(k), the after tax net proceeds would only be $6200. This is because they would owe $1000 in penalty for taking an early distribution plus $2800 in Federal Income Taxes. In reality, the liquidation of this retirement account yields a 62% pay out and a 38% tax and penalty on the total account value.
One other thought regarding early withdrawal – there are some situations where the IRS will waive the 10% penalty on early withdrawal. An example of this would be for dire and non-reimbursed medical expenses which do not exceed 7.5% of your adjusted gross income.
It is extremely important to tread carefully when manipulating any type of “qualified” account. Check additional rules and exemptions for early distribution on the IRS tax topics page.
Kurt Rusch, CLU, ChFC