If you're changing employers, do you know what will happen to the funds in your 401(k)? Lots of people on our Foolish discussion boards come looking for answers to that very question. So let's take a look at the options.

Generally, when you change jobs, you have three choices regarding that money:

  1. Leave it in the plan.
  2. Take it out and keep it all.
  3. Move it to an IRA.

Unless you have at least $5,000 in your account, most plans will force you to move your money out of the plan when you stop participating. 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. If you're satisfied with the investment choices you have in that plan, if your investment costs are lower than you can get elsewhere, or if you need the bankruptcy protection provided by qualified retirement plans, then leave your money right where it is. Otherwise, it's usually best to move the money. By doing so, you will most probably gain a wider choice of investment options at a lower cost.

You should almost never take the money and run. If you do, it may never again be placed in a retirement plan. You will lose all those years of tax-deferred compounding, and that could seriously jeopardize your income in retirement. You will also have to pay income taxes on what you keep. And worse, if you don't turn 55 by the year's end, you must pay a 10% early withdrawal penalty on that amount as well.

For example, this year, a married 35 year-old with a joint income of $75,000 is in the 28% federal income tax bracket. Perhaps this person is in a 4% state bracket as well. If so, and if the person kept his or her 401(k) money upon changing jobs, he or she would lose 42% of those proceeds to income taxes and the early withdrawal penalty. That means this person would keep only $580 out of every $1,000 paid from his or her plan. A $4,000 401(k) withdrawal would turn into just $2,320!

Given the potential tax loss they face by keeping the money, most folks will move their 401(k) to a traditional IRA. There are two ways to do that -- a "rollover" and a "direct rollover," or trustee-to-trustee transfer. Of the two ways to move plan money to an IRA, the direct, trustee-to-trustee transfer method is usually best. Let's look briefly at both methods.

In a regular rollover, you receive your plan assets via a check made out in your name. You may cash that check and do whatever you wish with the proceeds. But to avoid any taxation and penalty, you have 60 days from the day you receive that check to get that money to an IRA. Unfortunately, though, the check you get will be for only 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 gets distributed from the plan directly 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 that money! You must declare the missing 20% as income. Worse, you will also pay a 10% early withdrawal penalty on that sum when you're younger than 55 in the year you changed jobs. However, if you add that missing 20% to your IRA rollover, the government will refund the 20% withheld from your 401(k) check when you file your income tax return for the year -- assuming, of course, that you otherwise owe no more income taxes for the year.

That tax issue is why most Fools prefer the direct transfer method of moving money from a 401(k) plan to an IRA. In a trustee-to-trustee transfer, nothing is withheld for income taxes when the 401(k) account is closed. Any check, whether it goes to the IRA custodian or to you, will be made out in a form that prevents you from cashing it. Only your new IRA custodian can do so. And that means you will have no potential problems with the tax man, nor must you pull assets from other sources to make up for any money withheld from the 401(k) distribution for a potential tax bill.

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.

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Feel free to reach Fool contributor Dave Braze by email. The Motley Fool has a disclosure policy.