Job Changes and Your 401(k)

What should you do with your retirement savings when you leave your old employer?

Roy Lewis
Roy Lewis
May 23, 2005 at 12:00AM

You're a Fool, so you're taking advantage of the 401(k) plan offered by your employer -- but you're thinking about changing jobs. What do you do with your 401(k) money? You have a number of options.

One option we hope you don't elect is taking a distribution of your 401(k) funds. It's just not a good deal. If you're under age 59 1/2 (age 55 in some limited cases) and take a distribution, you'll not only owe taxes on it but also owe a 10% penalty tax. So, we don't see this as a viable option. In fact, it should be avoided at all costs -- it's a real last-resort type of thing.

That said, let's look at your other real options:

Leave 'em
Many employers will allow you to leave your 401(k) money in their plan after you leave the company. Additionally, you should know that employers generally can't force you to take your money out of their 401(k) plan when you leave, unless your balance is $5,000 or less. This option works well if you are satisfied with the investment choices and the investment returns provided by your prior employer's 401(k) plan. Additionally, since some plans allow you to take a loan from your 401(k) account, leaving the money in the plan -- as opposed to rolling it into an IRA -- allows you to take advantage of this rule, should the need arise.

But there are disadvantages. One drawback is leaving money in the former employer's 401(k) plan if the plan investments are limited to only the former employer's stock. In this situation, since all of your 401(k) money is in one investment, you run the risk of losing that money if there is a decline in the value of the stock. Another disadvantage of leaving the 401(k) funds with your prior employer is that it will not allow you to invest Foolishly. You can likely do a much better job with your 401(k) money in a self-directed conduit IRA account than you could with the mutual fund choices in the 401(k) account.

Move 'em
If your new employer has a 401(k) plan and permits transfers from other employers' 401(k) plans (it's not mandatory for them to do so), you can transfer the money from your former employer's 401(k) plan to your new employer's 401(k) plan. This option is advantageous only if the investment choices offered by the new employer's plan are better than those offered by the former employer's plan. It also preserves the opportunity to take a loan from the plan if the need arises -- and if the new employer's plan offers that option. But again, if the mutual fund choices that your new employer's plan offers won't likely perform to your expectations, consider Foolishly investing your funds by moving the 401(k) funds to a conduit IRA account.

Transferring your money to a new employer's 401(k) plan generally can be done in one of two ways. You can take a distribution of the funds from your prior employer and deposit it (roll it over) into the new employer's plan. Second, if the new plan permits it, you can make the transfer through a trustee-to-trustee transfer.

The trustee-to-trustee transfer option is always preferable because the IRS requires that if you take a distribution, even one that you will roll over to another 401(k) plan, the employer must withhold 20% of the amount distributed for tax purposes. You won't be able to get this money back until you file your tax return for the year in which the distribution took place and claim that amount as taxes withheld. Additionally, if you aren't yet 59 1/2 and don't deposit the distribution check and/or the amount withheld -- which must be obtained from sources outside the distribution -- within 60 days of the distribution, those amounts will be subject to income taxes and the 10% early distribution penalty. More about this later.

IRA 'em
The final option available to you is to transfer the money to a traditional IRA (not a Roth IRA). If you choose a self-directed traditional IRA brokerage account, you can completely control your entire investment and can use the funds to buy any investment offered by the brokerage -- including stocks, bonds, and/or mutual funds. You aren't limited to the investment choices provided by either your old or new employer. But if you do make the transfer to an IRA account, you'll lose the opportunity to take loans, since loans against an IRA account are strictly prohibited. (For more info on choosing a discount brokerage for your IRA, visit our Choosing a Broker Center.)

Be careful, though, because as with a transfer to a new employer's 401(k) account, how you make the transfer is critical. If you take a distribution and then open an IRA account, you'll find that the required 20% withholding will reduce your distribution. And if you don't roll over the entire amount of the distribution (including the 20% withheld), you'll get hit with taxes and potential penalties on the amount that wasn't rolled over. This means you'll have to dig into your pocket to roll over the appropriate amount.

Example: In May 2004, John, age 45, left his job. He had $100,000 in his employer's 401(k) plan. John decided to take the money from the plan and open a self-directed IRA account. However, John never filled out the paperwork to make a trustee-to-trustee transfer. As a result, on July 1, 2004, John's former employer sent him a distribution check for $80,000 -- John's $100,000 account balance, less 20% withholding. To avoid all income taxes and penalties, John needed to not only deposit the $80,000 check by Sept. 1, 2004, (i.e., within 60 days of the distribution) but also deposit $20,000 (the amount withheld by his employer) by that same date. The $20,000 must come from sources outside of the distribution. If John does not have $20,000 from other sources, that amount will be treated as a distribution and will be subject to income taxes and penalties.

Sure, John will get this $20,000 back in the form of taxes withheld when he files his tax return, but that will take a number of months. Why go through this hassle when a trustee-to-trustee transfer will avoid the 20% withholding and will not make you scramble to find funds to cover the withholding amount?

What if you are undecided whether to transfer your 401(k) funds to your new employer's plan or to a brokerage IRA? Or what if you are between jobs and don't know who your new employer will be or whether it will have a 401(k) plan? In these cases, you'll likely want to transfer the money to a traditional IRA until the decision is made. An IRA can act as a holding account until you decide what to do with the money. If the decision is, ultimately, to transfer the money to a new employer's plan, you can direct the broker to do just that.

But if you want to keep this option open, you must remember that this "conduit" IRA account must not receive any other IRA distributions or contributions from any other sources. So if you are interested in keeping your options open, make sure to open a completely separate Rollover IRA account for these 401(k) funds, and keep them completely separate from all of your other IRA transactions (e.g., Roth, traditional, SEP, etc.).

Ready for retirement?
Remember, these are your retirement funds. The better you can protect them and invest them, the farther along the road to a glorious retirement you'll find yourself.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.