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Changing jobs? Study options for 401(k)
Standing pat, rolling into new company's plan or opening up an IRA each has pros and cons
Janet Kidd Stewart
Your Money columnist
Posted January 21, 2007
By now you've probably been lectured on the perils of cashing out your 401(k) retirement plan when you leave a job.
You'll pay income taxes and possibly a 10 percent early withdrawal penalty (there are a few exceptions). Plus, using the money today means you'll be that much further behind in reaching your retirement goal tomorrow.
Once you've pledged not to cash out, however, some important choices have to be made that can substantially affect your retirement options down the road.
Leaving the money with a former employer, rolling it into your new company plan or stashing it in an individual retirement account each comes with its own set of pros and cons.
Let's start with leaving the money right where it is, assuming that's an option.
Most companies require low-balance accounts--those with less than $5,000--to be distributed out of the plan. If you have between $1,000 and $5,000, the company must open a traditional IRA and roll the money there. Amounts below $1,000 can be cashed out and sent directly to the employee, minus any early withdrawal penalties and tax withholding.
Why have your money stay someplace you wouldn't?
The only real advantage to leaving your 401(k) with an old employer is if the plan gives you access to a fantastic mutual fund that is closed to new investors, or if expenses are dramatically lower than what you could replicate at a low-cost mutual fund supermarket, said Rande Spiegelman, vice president of financial planning at the Schwab Center for Investment Research, a unit of Charles Schwab Corp.
Rolling the money to a new employer's plan can be simpler to track because you have all of your workplace savings in a single account, and that allows you to borrow from the money if you really need to, Spiegelman said. But you limit yourself on investment choices and don't get to participate in some new rules that allow taxpayers to convert to Roth IRAs for tax advantages down the road.
"Most often, the best decision is to roll it into an IRA. It gives you the most flexibility," Spiegelman said.
Sometimes an employer might be picking up a nice chunk of administrative expenses in the plan, but it might not be meaningful if you compare that with costs at a fund firm that charges ultralow fees for larger accounts, said Mark Luscombe, a senior federal tax analyst with CCH Inc. in Riverwoods.
Most company retirement plans have a dozen or fewer investment choices, compared with IRA holders who keep their accounts at mutual fund firms offering hundreds of fund choices and allowing access to other fund families' products.
Another reason for transferring the money to an IRA surfaced in last year's Pension Protection Act. Under the law, all retirement savers will be allowed to convert their traditional IRAs to Roth IRAs beginning in 2010.
That means people who typically would be phased out of Roth IRAs because of higher incomes will be allowed to pay taxes on their traditional IRAs and convert them to Roth IRAs, which grow and are withdrawn tax-free in retirement.
Paying taxes on a large IRA will be painful, but financial planners say tax rates in the future will almost certainly be higher, given the increasing demands of an aging population, and it will be a huge relief for seniors to have a tax-free stream of income in retirement.
In a few specific cases, however, an IRA rollover might not be the best option.
You typically can borrow against a workplace-qualified plan, but you can't borrow against an IRA, Spiegelman noted in a recent letter to clients.
Also, if you have a significant amount of company stock in your 401(k), you should calculate the benefits of favorable tax treatment before automatically rolling the whole plan into an IRA.
Using a strategy known as net unrealized appreciation, departing workers can take a lump-sum distribution of company stock, paying ordinary income tax on the shares' cost basis.
The difference between the basis and the fair market value, the net unrealized appreciation, is subject to the long-term capital gains tax rate when the shares are sold, said John Nersesian, managing director of the Wealth Management Services Group at Nuveen Investments in Chicago, who wrote an article on the topic for the Journal of Financial Planning.
That allows holders to liquidate immediately for diversification and lessens the tax bite by using the lower capital gains rate for the stock appreciation.
Meanwhile, roll the remainder of your company plan into an IRA so you avoid the early withdrawal penalty.
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