What to do With Your 401(k) When You Change Jobs

Leaving a job to take a new position (or look for one) can be pretty stressful. There's a lot to think about, including what to do with the 401(k) you had at your old job. Making a smart decision could save you some money, not to mention keep you on track for a comfortable retirement.

Four choices for your 401(k)

When you leave a job where you contributed to a 401(k), you have four basic choices:

• Take the cash
• Leave the money where it is
• Roll it over into your new employer's 401(k)
• Roll it over into an individual retirement account (IRA)

Taking the money

The most tempting choice may be to take the money, especially if you're unemployed and could use the cash. I'm still young, you think. There's plenty of time to make up the money I'm skimming from my 401(k). But unless you have absolutely no choice, don't do it.

If you take money out of your 401(k) before the age of 59 (or before age 55 in the case of "separation from service) you have to pay a 10% federal penalty (state penalties may also apply). Even if penalties don't apply, you'll still be subject to federal, state and, in some cases, local income taxes. What's more, the government will help itself to 20% of your withdrawal as an advance on your tax bill.

What's left after a $56,000 distribution from a 401(k)

For example, if you cash out of a 401(k) worth $56,000, you could end up paying a federal penalty of $5,600 plus, say, 28% in federal income tax (20% of which is withheld from the distribution). Your $56,000 has turned into $34,720. And that doesn't even include any state and local taxes and penalties you may owe.

Taking cash from your 401(k): some pros and cons

Pros	Cons
Immediate use of your money.	Money loses tax-deferred status.
	20% mandatory withholding.
	May be subject to a federal 10% early withdrawal penalty, state penalties where applicable, and additional federal, state and local taxes.
	Lose flexibility to move into qualified plan or IRA after 60 days.

What's more, the opportunity cost will likely be huge. That $56,000, left to grow at, say, a hypothetical 8% annual rate of return1 would amount to roughly $563,500 some 30 years from now. That kind of money would come in handy during retirement. And that's the point, after all.

But what if I only take out $5,000 you say. You might still end up paying a $500 penalty plus $1,400 in federal tax (assuming a 28% bracket), leaving you with just $3,100 left over - with possible state and local taxes still to pay. That $5,000 growing tax deferred at our hypothetical 8%1 for 30 years could become $50,300 in retirement money.

A car, travel, credit card debt, even a home or a college education usually aren't good enough reasons to dip into your 401(k), much less rent and groceries. Don't raid your retirement assets unless you have no other choice.

Keeping your old 401(k) or rolling it over

Here are some wiser choices; in each case, your money continues to grow tax deferred for retirement:

• Leave your money in your old 401(k) even though you don't work at that company anymore (but make sure you're comfortable dealing with your former employer).
• Roll over the money directly into your new employer's 401(k) when you take a new job.
• Roll it over directly into your own IRA.

Most employers pre-select the mutual funds available in their 401(k) plans, which can be a plus or a drawback. The ability to choose from 15 or 20 funds, for example, provides a nice range of choices without the hassle of screening hundreds of funds yourself. But if your 401(k) offers only three or four fund selections, you may want to think about an IRA rollover (more below).

Keep in mind that a 401(k) is a "one size fits all" retirement plan. Your company has to manage the plan with all of its employees in mind, not just you. Expect less flexibility than you would generally get with your own IRA. On the plus side, your employer will likely pay any administrative fees - not necessarily so with an IRA.

Stay in your old 401(k): some pros and cons

Pros	Cons
Avoid current income taxes, penalties and 20% withholding.	Investment choices limited to employer's plan.
Money continues to grow tax deferred.	Plan may limit withdrawals and exchange between investments.
Retain ability to roll over at a later date.

Roll over to new employer's 401(k): some pros and cons

Pros	Cons
Avoid current income taxes, penalties and 20% withholding.	Investment choices limited to employer's plan.
Money continues to grow tax deferred.	Plan may limit withdrawals and exchanges between investments.
Easier to track retirement assets.
May be able to borrow against your 401(k).

Rolling over to your own IRA

The other possibility is to roll over your 401(k) money into an IRA. Like a 401(k), an IRA keeps your retirement money growing tax deferred, but with two major advantages: flexibility and control.

• Flexibility. An IRA generally allows you to invest your money however you like - mutual funds, stocks, bonds and so on. You'll likely have help and advice from the financial institution that holds the IRA, and you can reallocate your investments whenever and however you please (minus any trading fees, of course).
• Control. With an IRA, you can invest and access your money without having to go through a 401(k) provider.

However, there are some caveats:

• A qualified employer plan, such as a 401(k), may have more legal protection from creditors than an IRA. Although the level of IRA protection differs under various state laws, a 2005 U.S. Supreme Court ruling (Rousey v. Jacoway, 03-1407) shields traditional IRA assets in bankruptcy when the funds are found reasonably necessary for the account holder's or his/her dependents' support. Furthermore, federal bankruptcy reform signed into law in 2005 protects from creditors - for any reason - up to $1 million held in traditional and Roth IRAs.
• You can usually borrow from your current 401(k) plan, but not from your IRA (not that borrowing from your future retirement is a good idea, except in cases of extreme need).
• If you have company stock in your 401(k) you should think twice before rolling it over into an IRA. Company stock held in a 401(k) could receive favorable tax treatment if it's gone up in value and you have it distributed directly. Such favorable treatment doesn't apply if the company stock is rolled over into an IRA, though there can be benefits to this choice as well.

Rollover IRA: some pros and cons

Pros	Cons
Avoid current income taxes, penalties and 20% withholding.	Can't borrow against assets.
Money continues to grow tax deferred.	No special distribution alternatives such as net unrealized appreciation (NUA) treatment for distributions of company stock, or forward averaging.
Choose your own investments.	May have to pay annual fee.
Maximum flexibility—roll IRA assets back into a 401(k) or convert to a Roth IRA at a later date.	Beyond state law, traditional IRA assets are generally protected from creditors to the extent the funds are found reasonably necessary for support (U.S. Supreme Court). Traditional and Roth IRA assets are protected for any reason only up to $1 million under federal bankruptcy law.
Easy access to your investments.

There you have it: four basic choices for what to do with your 401(k). You may want to do some more research to figure out the best choice in your particular case, or even get advice from a financial or tax advisor. Lastly, don't forget about the power of tax-deferred compounding: Be sure to contribute to the 401(k) plan at your new job and, if you can, continue making contributions to your IRA.

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