Retiree Portfolio Transfer or Roll Over Your 401(k)?

In general, when you leave your job, you may leave your vested 401(k) money in the plan, take it and pay all taxes plus any early withdrawal penalty, or move it to an IRA. Most of us will choose the IRA option. There are two ways to do that: a rollover or a direct transfer. To avoid unpleasant income tax consequences, a direct transfer of 401(k) funds to an IRA is the best way to accomplish that move.

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By David Braze (TMF Pixy)
March 12, 2001

Let's say that very, very soon you will leave your current job. What will you do with your vested retirement plan money, such as the funds in your 401(k)? I'm surprised by how often that question arises on our discussion boards. Thus, I thought it might be useful to talk about a few of the options.

When you leave your job, you generally have three choices regarding the money in your 401(k). You may leave it in the plan, take it all and run, or move it to a rollover (conduit) IRA. Unless you have at least $5,000 in your account, most plans will force you to move your money out of the plan at your departure. If you have $5,000 or more, though, you may leave the money in your 401(k) until the normal retirement age specified by that plan. You should consider keeping the money in your 401(k) only if:

  • You are satisfied with the investment choices you have in that plan.
  • Your investment costs are lower than you can get elsewhere.
  • Your financial situation is such that you need the bankruptcy protection provided by qualified retirement plans.
  • Your plan allows former employees to borrow against their 401(k) accounts and you believe you will want to do so in the future.

Otherwise, it's usually best to move the money. By doing so you will gain a wider choice of investment options at lower cost.

Should you take the money and run? Almost always, the answer is a resounding "No way, Jose!" If you take the money to keep, it may never again be placed in a retirement plan. You will lose all those years of tax-deferred compounding, which could seriously jeopardize your income in retirement. Additionally, you will have to pay income taxes on what you keep, and most will pay a 10% early withdrawal on that amount as well. That means someone in a 28% federal and 4% state marginal income tax bracket would lose at least 32% of the proceeds, and probably 42% when the early withdrawal penalty is included. In the latter case, that means you would keep only $580 out of every $1,000 paid from that plan. Uncle Sammy and Auntie State just don't deserve that much of your hard-earned stash.

Most folks will move their 401(k) monies to an IRA. Be aware there are two ways to do that. One method is called a "rollover" and the other is called a "direct (or trustee-to-trustee) transfer." Both are discussed in detail in "Getting the Loot to an Individual Retirement Account." Of the two ways to move plan money to an IRA, the direct transfer method is usually best. Let's look briefly at both methods.

In a rollover, you receive your plan assets via a check made out in your name. To avoid any taxation and penalty, you have 60 days from the day you receive that check to get those proceeds to an IRA. Unfortunately, though, the check you get will only be for 80% of the 401(k) account balance. That's because, by law, the plan must withhold 20% of your account balance to pay for any possible income taxes on the amount that's distributed through the check the plan issues to you. What a bummer!

To complete a 100% rollover of your 401(k) money, you must come up with the missing 20% from other assets, probably by removing money from your bank account. You would then add that 20% to the 80% you got from the plan, and deposit those proceeds into an IRA within 60 days.

If you fail to add those extra funds, then at the end of your tax year the Internal Revenue Service will call the missing 20% a taxable distribution -- even though you never actually received those funds. Result? You must declare that 20% as income. Worse, you will also pay a 10% early withdrawal penalty on that sum if you're younger than 59 1/2. (If you pay the 20% from other savings, the government will refund the 20% it withheld when you file your income tax return provided you otherwise owe no more income taxes for the year.)

Now you know why I prefer the direct transfer method of moving money from your 401(k) plan to an IRA. A direct transfer results in none of the problems cited above. Nothing is withheld for income taxes when the 401(k) account is closed, so you have no potential problems with the tax man, nor must you pull assets from other sources to make up for the 20% withheld. In a rollover, you have full control over the money. In a direct transfer, you never see the cash because it flows directly from the 401(k) plan custodian to your desired IRA custodian.

Worried about how to arrange such a transfer? Don't be. Both your plan custodian and your desired IRA custodian do it all the time, so both can guide you through the process. Just tell them what you want to do, then follow the administrative instructions they provide. Remember that any check issued by the plan should NOT be made out in a way that allows you to cash it. As long as it isn't, you will have no problems with income taxes.

Lastly, you may wish to have the money transferred to a separate and distinct IRA of its own. That keeps those funds eligible for a future transfer to a new employer's 401(k) plan when the new plan accepts rollover money from an old employer's plan. If you mix your 401(k) money with IRA money that did not come from an old employer's qualified retirement plan, that money forevermore loses its eligibility for a future transfer to a new employer's plan. If retaining that transfer eligibility is important to you, then forewarned is forearmed.

And speaking of IRAs, remember there's still time to make a contribution for the 2000 tax year. Check out our IRA Eligibility Calculator to see which type may be right for you.

Comments? Post away on the Retired Fools or the Retirement Investing boards.

Best to all...Pixy

Dave Braze remembers the days when 401(k) plans and IRAs were unknown. Do you think he invested in buggy whip production companies, too? It wouldn't surprise us if he did. Luckily for him, though, The Motley Fool is a website dedicated to the concept of investors writing for investors.