By MARKET MATTERS BY BRIAN HEPP
Not that long ago, a good number of workers in this country would spend an entire career with one employer and retire with a company pension plan. In many respects, that scenario is a thing of the past. Not only are traditional pension plans disappearing, chances are you may end up changing careers — not just jobs — at least once or twice before you’re ready to retire.
When you switch jobs, one of the most important financial decisions you may be faced with is what to do with the money in your company 401(k) plan. While it may be tempting to withdraw that money and use it to cover other expenses, doing so could have very detrimental effects on your overall finances. Unfortunately, studies have shown that nearly half of workers do cash out of their 401(k) plans when they leave a job, according to Hewitt Associates LLC.
In addition to depriving yourself of valuable retirement savings, early cash-outs can subject you to hefty state and federal income taxes. You also face may an early withdrawal penalty of 10 percent, reducing the value of your hard-earned savings even more. So, if you find yourself in the position of changing jobs, you may be wondering what your options are for your retirement plan funds.
Generally, you have four alternatives for handling the assets in your former employer’s retirement plan. Your options include rolling them into an IRA; taking a cash distribution; leaving the assets in the plan; or moving them to a new employer’s plan. We’ll take a brief look at each of those strategies.
If you’re changing jobs or retiring, your best bet is usually to roll your 401(k) assets over into an IRA account. By doing so, you retain the tax-deferred growth potential of your investments. What’s more, you can maintain all of your IRAs in the same place, making it easier to manage your retirement assets and analyze your overall asset allocation.
An IRA also offers the additional benefit of giving you access to your money when you need it but just know that withdrawals prior to 59 years old may be subject to a 10 percent IRS penalty. If you lose a job due to downsizing or some other reason, you might not be able to draw an income stream from retirement plan assets left with a former employer. With an IRA, you have the flexibility to determine how much income you need, and you can take withdrawals when you want. Taxes and IRS penalties may apply.
Cashing out should generally be considered a last resort. If you withdraw all your funds each time you change jobs, you’ll systematically erode one of your principal sources of retirement income. To illustrate, with lump sum distribution, on top of income taxes and IRS penalties you may be subject to, your employer also will be required to withhold 20 percent of the taxable amount of your distribution and send it to the IRS as a prepayment of the taxes that will be due. As you can see, cashing out is not the most desirable option.
Leaving your assets in your former employer’s plan may be an option that’s available to you, but doing so could create complexities in managing your investments. Keep in mind you will be limited to the plan’s investment alternatives, and your employer also will control when and how you access your retirement savings in the future. Leaving the assets where they are requires no action on your part, but it may not be worth the potential hassles it could create.
Finally, you may be able to move your retirement plan savings into a new employer’s plan when you change jobs. However, doing so may involve many of the same benefits and drawbacks of leaving your money in a former employer’s retirement plan. You’ll need to make sure your new employer’s plan permits transfers or rollovers from other types of plans before you decide to go that route.
Originally published in the Santa Monica Daily Press print edition on July 13, 2006. Read the original PDF.