U.S. workers change jobs every 5½ years, on average.1 These changes often include a very important decision regarding the assets in their former employer’s 401(k) or other defined-contribution plan. Unfortunately, about 45% of people cash out their balances in workplace plans when changing jobs, and the percentage rises to 55% for those with balances of $5,000 or less.2
When you take a distribution from your 401(k), you will owe ordinary income tax on the withdrawal and possibly a 10% early-withdrawal penalty if you are under age 59½. The biggest penalty, however, might be the loss of future retirement assets. Consider that even a $5,000 401(k) balance could grow to more than $30,000 over 30 years, assuming a hypothetical 6% annual growth rate.3 Cashing out a larger balance would have larger consequences.
Preserving Tax-Deferred Savings
Depending on your situation, you may have several other options for your 401(k) assets when changing jobs. All of them generally preserve the tax-deferred status of your retirement funds and offer the potential for continued tax-deferred growth.
Keep assets in former employer’s 401(k). This could be a convenient short-term option (if allowed by your former employer), but you will not be able to make future contributions. Keep in mind that many employer plans may automatically transfer balances under $5,000 to an IRA and automatically cash out balances under $1,000.
Transfer assets to a new plan. If your new employer offers a 401(k) or other workplace retirement plan that accepts rollovers, this strategy might make sense if you are comfortable with the fees and investment options in the plan and expect to stay with your new employer for some time.
Roll assets to an IRA. IRAs typically provide a wider variety of investment options than employer plans and enable you to consolidate your retirement assets in a single account. Moreover, the IRA is yours to control, regardless of your employment situation.
For either type of rollover, it’s more efficient to execute a trustee-to-trustee transfer from your old plan to the new plan (or IRA), either directly or in the form of a check made out to the new trustee. If you receive a check payable to you from your former employer’s plan, 20% will be withheld for federal income taxes. You have 60 days from the date of the check to roll over the entire distribution — including the tax withheld — to an IRA or another employer-sponsored plan; otherwise, the amount not rolled over will be considered a taxable distribution.
Distributions from traditional IRAs and most employer-sponsored retirement plans are taxed as ordinary income. Withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty, with some exceptions.
1) Employee Benefit Research Institute, 2015
2) InvestmentNews, February 17, 2015
3) This hypothetical example of mathematical principles is used for illustrative purposes only and does not represent the performance of any specific investment. Fees and expenses are not considered and would reduce the performance described if they were included. Actual results will vary.
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