September 10, 2010

Your Financial Future and Your 401(k)

Millions of Americans threaten their financial future by failing to roll over 401(k) funds when they change jobs. Too many people see leaving a job as an opportunity to get their hands on the cash they’ve been saving for retirement, but you can do irreparable harm to your financial future by doing so.

When you change jobs, you’ll have to make a decision about what to do with the money you’ve contributed to your employer’s 401(k) plan. There are three major options: leave the money in your former employer’s plan, take the money out, or roll it over.

401K Options

If your vested 401(k) funds total $5,000 or more, your employer is legally required to allow you to leave your funds in the company plan if you choose to do so. This may be a good option for you if you’re happy with the performance of your employer’s plan, it’s a bad time to cash out (you’ve lost money during a market slump, for example), or you have a waiting period at your new job before you’re eligible to roll your funds over into that plan.

Your second option is to take the money out of the 401(k) plan and not roll it over into another qualified plan. If you elect this option, your 401(k) provider will first deduct 20% and send it to the IRS to be applied to your income taxes when you file your return at the end of the year. The taxes deducted may or may not be enough to cover your tax liability. For example, if you’re in the 10% tax bracket, you’ll probably get some money back, but if you’re in the 28% tax bracket, you may owe an additional 8%. If you’re under age 59 1/2 (or 55 in some circumstances), you’ll also owe an additional 10% in early withdrawal penalties.

401K Withdrawal Penalties

Here’s how the above scenario may play out: You’re in the 28% tax bracket and are under 55 at the time you leave your job. You decide to have your 401(k) balance of $100,000 paid directly to you.

$100,000 – 401(k) Balance
– 20,000 – 20% Withholding
– 8,000 – Additional taxes (28% less 20% withheld)
– 10,000 – 10% early withdrawal penalty
$ 62,000 – Balance

IRA Facts

In addition to the federal income taxes listed above, you’ll also have to pay state income taxes on the amount you withdrew, leaving you with approximately 57% of your hard-earned money (assuming a 5% state tax rate).

You can avoid paying current taxes and penalties if you roll the money into your new employer’s 401(k) plan or an IRA. This scenario may look like this:

$100,000 – 401(k) balance
-0 – Taxes withheld
-0 – Additional taxes
-0 – 10% early withdrawal penalty
$100,000 – Balance

You can set up an IRA at most banks or financial institutions or directly with most mutual funds or publicly traded companies. In most cases, this can be done easily online or via mail. Be sure to request that the money be sent directly to the new 401(k) plan administrator or IRA administrator to avoid incurring taxes. Rolling the entire amount over to another tax-deferred plan should provide you with significantly higher retirement funds, especially if you are many years from retirement. If you take the money out of a tax deferred plan, you lose the power of compounding the full amount over the years left until retirement, possibly costing you hundreds of thousands of dollars.

So, if you’re faced with the decision of what to do with your retirement savings when you change jobs, remember: don’t throw away your 401(k)!

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