Don't Make This 401(k) Mistake in 2016

It's easy to fall into this trap, but fortunately, it's also easy to avoid it.

Dan Caplinger
Dan Caplinger
Jan 23, 2016 at 2:41PM
Investment Planning

Image source: via flickr.

Your 401(k) can be your best tool in saving for retirement, but it can also be your biggest source of regret. Many 401(k) investors have seen the downside of their retirement investments in recent months, as the downturn in the stock market last summer sent the average saver's 401(k) balance down by $5,700, hitting $84,400 according to Fidelity Investments. In order to make the most of your 401(k), it's critical to avoid a major mistake that looms for nearly everyone at some point in their careers.

The biggest mistake you can make with your 401(k)
The situation in which most people go wrong with their 401(k) plans is when they decide to change jobs or retire. When you're making a career change, it's natural to think that you automatically need to take your 401(k) money out of your former employer's control. But if you don't manage that process correctly, it can be the most costly decision you'll ever make.

The worst thing about this mistake is that it can undo years of smart financial moves. Regularly saving money and taking advantage of an employer match in a 401(k) is one of the best ways to prepare for retirement. But when it comes time to consider what to do with your retirement money once your job ends, all it takes is a single moment to wreck a lifetime of prudent saving.

Specifically, the mistake that can cost you a huge portion of your retirement savings is to withdraw money from your 401(k) and simply cash the check or put it into your regular bank account. By doing so, you'll face three consequences:

  • You'll pay tax on the withdrawn amount from a traditional 401(k) account.
  • You'll pay early withdrawal penalties if you were younger than age 55 when you retired.
  • Worst of all, you won't get any future tax-deferred growth on the money that you withdrew.

With those costs involved, it's essential to find an alternative. Below, you'll find three.

1. Leave the money where it is.
In many cases, you have the option to leave your money in your old employer's 401(k) account. This can be a useful choice if the plan offers good investment options that you're unlikely to find elsewhere. For instance, large employers often provide access to low-cost institutional mutual funds with cheaper fees than a similar retail mutual fund.

You won't necessarily be allowed to keep your old employer's 401(k) account if you have a small balance. Current guidelines allow your old employer to cash you out automatically if your balance is less than $1,000. For those with balances between $1,000 and $5,000, your employer can move your money to an IRA it creates on your behalf. It's therefore critical to follow your 401(k) account balance to know what is likely to happen after you leave work.

2. Move your 401(k) money to your new employer.
If you change jobs and your new employer also offers a 401(k), you can typically move the money from your former employer into your account with the new employer. You won't get matching contributions on it, but it will be fully vested, and you'll have complete control over the money without having to pay any taxes or penalties.

The best way to handle such a move is to have your former employer transfer the money directly to your new employer. That way, there will be no chance of any adverse tax consequences, because you'll never have taken possession of the money. Bear in mind, though, that some employers limit the ability to move former employer 401(k) money into a new 401(k) account. Check with your new employer to get details.

3. Moving your 401(k) money into an IRA.
The other option you always have when you leave work is to take your 401(k) money and move it into an IRA. Again, you have two ways to make the move, either by having your former employer directly transfer the money to the financial institution handling the IRA, or by having your former employer cut you a check and then depositing it into the new IRA yourself.

If you go the latter route, you have only 60 days to get the rollover made. Otherwise, the distribution will be treated as a normal taxable withdrawal, subject to any penalties that might apply based on your age. Because of the threat of tax complications, it's preferable just to go the direct-transfer route whenever possible.

Handling your 401(k) well requires discipline and knowledge. Being able to avoid key mistakes like mishandling your 401(k) account after a career change is crucial to let you reach your full potential.