Chapter 7
Weighing Your Options When You Leave Your Employer
IN THIS CHAPTER
Moving your money to your new job
Taking taxes into consideration
Letting your money stay when you go
Giving yourself a big goodbye present
Handling company stock
When you stop working at the employer that sponsors your 401(k) plan, some restrictions on your money magically drop away. Except in a few extreme cases, you’re allowed to withdraw your money for any reason at all (it doesn’t have to be a hardship), although you still have to pay applicable taxes and penalties.
This newfound freedom makes about a third of 401(k) participants giddy enough to do something silly — that is, take the money and run. That’s a bad idea, and I tell you why later in the chapter. Fortunately, there’s an easy way to avoid pillaging your 401(k) — do a rollover. You can transfer your 401(k) money directly from your former employer to an individual retirement arrangement (IRA) — also referred to as an individual retirement account — or to your new employer’s retirement plan (if it allows rollovers), without owing tax. In the new account, the money continues to grow tax-deferred, with no income tax on annual earnings.
If you don’t do a rollover right away, you can most likely leave the 401(k) money in your old employer’s plan while you consider your options. This chapter explains how to preserve your 401(k) tax advantage when you change jobs and how to avoid costly mistakes with your retirement money.
Your employer is required to give you a detailed written explanation of your options when you leave a job. Chapter 17 explains your options when you retire, which may be slightly different.
Taking Your Savings with You
When you change jobs, you can take your 401(k) money with you — and keep the tax advantages — by putting it into your new employer’s 401(k), 403(b), or 457 plan, or into an IRA.
Transferring your money to a new employer’s plan or an IRA is known as a rollover or trustee-to-trustee transfer. See Chapter 10 for more on rolling your money into an IRA.
Many employers require you to work for a minimum number of years before the employer contributions are yours to keep (known as vesting). Your contributions are always yours.
Because your 401(k) is portable, or transferable, you can build up a retirement nest egg even if you change jobs frequently. This beats the traditional defined-benefit pension plan (in which you receive a set amount from your employer each month in retirement, if you qualify). With those plans, you can lose all retirement benefits if you don’t work at the company for the minimum vesting period — this can be at least five years, or even longer at some companies.
A Rolling 401(k) Gathers No Taxes
When you leave your job, one of the many forms that you’ll likely have to fill out is a 401(k) distribution election form. Distribution is employee-benefit-speak for the payment to you of your vested 401(k) money.
The most sensible thing to do with your 401(k) from a tax-management point of view is a direct rollover (also known as a trustee-to-trustee transfer) of the money. With this type of rollover, your old service provider writes a check directly to the financial institution where your new account is. The money goes directly from your 401(k) plan into another tax-deferred account — an IRA or your new employer’s 401(k) plan, 403(b) plan, or 457(b) plan. 403(b) plans are offered by many nonprofit organizations and 457(b) plans are offered by state and local governments. By doing a direct rollover, you don’t have to pay any tax on the money when it comes out of your old employer’s 401(k). The money also continues to grow tax-deferred in the new account.
Many participants wonder whether it’s better to roll their 401(k) into an IRA or into another employer’s plan. It really depends on your situation. Check Chapter 10 for rollover info.
Instead of transferring the money directly to the new plan or IRA, the service provider may write you a check for the 401(k) balance, which complicates things for you.
If the check is payable to you, the service provider is required to withhold 20 percent of the account value as federal withholding tax. So, if you have $10,000 vested in your account, you’ll receive a check for only $8,000.
In order to avoid paying income tax and an early withdrawal penalty, you have to deposit the $8,000 check plus $2,000 of your own money into an IRA or your new employer’s plan within 60 days of receiving the distribution. (The IRS will return the $2,000 to you when you file your tax return if you do the rollover correctly.) The amount that you don’t deposit in the new account will be considered a cash distribution on which you’ll owe applicable tax and penalties. The IRS is firm on this 60-day limit. The only leeway is in the case of a national disaster when the IRS can decide to extend the 60-day period.
Your employer may also require your spouse to sign if you’re married because you have the right to name a beneficiary other than your spouse if the money is transferred to an IRA. If so, the spouse’s written consent is usually required on the election form, and it must be notarized or approved by a plan representative.
Realizing that account size matters
If your account balance is less than $5,000, you may be forced to take the money out of your employer’s 401(k) plan when you leave. If it’s more than $1,000 (and less than $5,000) and you don’t tell your employer what you want to do with the money, your employer can automatically roll the money into an IRA on your behalf. If the balance is $1,000 or less, your employer can simply issue a check to you for the entire amount without giving you any alternatives, but you’ll owe tax and penalties on the money.
Let your employer know right away that you want to do a rollover if your balance is less than $1,000 to prevent paying taxes and penalties.
If your vested 401(k) balance is $5,000 or more, and you’re younger than the normal retirement age specified in the plan document (usually 65), your employer is required to let you leave your money in the 401(k) if you want to. Leaving your money in the plan can be a useful strategy, at least as a temporary measure. See the section “Leaving Money with Your Old Employer” later in this chapter for details.
Moving your money to your new employer’s plan
You may be able to roll the money over into your new employer’s plan. You may decide to do this for a number of reasons, including the following:
- Your new employer has a terrific plan with great funds and low expenses.
- You want to consolidate all your retirement savings in one place for ease of management.
- You think you may want to take a loan someday (remember, you can’t take a loan from an IRA).
Before you decide to roll over your 401(k) into the new employer’s plan, make sure you get a copy of the new plan’s summary plan description to find out all the rules your money will be subject to. After the money is in the 401(k) plan, you may not be able to withdraw it and move it into an IRA unless you leave your job, so be certain about the rollover before you do it.
You also need to find out whether your new employer’s plan accepts rollovers. In theory, you’re allowed to roll a 401(k) plan into another 401(k) plan or into a 403(b) plan or 457(b) plan. In practice, though, not all employer plans accept rollovers. If yours doesn’t, you can leave your money in your old 401(k) or roll it into an IRA to preserve the tax advantage. (See “Leaving Money with Your Old Employer,” later in this chapter and Chapter 10 on rollovers.)
Your new plan may require you to wait until you’re eligible to participate before accepting a rollover from your old 401(k). Although many employers allow you to roll money into the plan before becoming eligible to contribute, some employers restrict the availability of rollovers until you actually become eligible for the plan. For example, if your new employer has a waiting period of one year before you can contribute to the 401(k), you have to wait one year to roll the money into the 401(k). In that case, you can either leave your money in your former employer’s plan or move it to a rollover IRA, ready to be transferred into the new 401(k) when the time comes.
Waiting for the money to transfer
After you decide to roll over your 401(k) money into an IRA or a new employer’s plan, the transaction may take a while to happen. I’ve heard from participants who’ve had to wait months before their former employer released their money.
Your plan is allowed to retain your money as long as it wants, but no longer than the “normal retirement age” specified in the plan document. Some companies restrict money in this way for up to five years after an employee leaves. One reason that an employer may set up a plan this way is to help retain good employees. Delaying distributions prevents an employee from quitting simply to access 401(k) money. Employees in this situation usually ask me whether their former employers can legally hold on to the money. The answer is “yes.” Amazingly (and somewhat frighteningly), under federal law, a plan is only required to distribute your money when you reach retirement age. (More specifically, it must be paid no later than 60 days after the end of the plan year when you reach the plan’s normal retirement age, which is often 65.)
Benefit distributions may be delayed for administrative reasons. Employers that make profit-sharing contributions typically do so just before filing their corporate tax return, which can be 9½ months after the end of the year.
The good news is that most employers want to get rid of the responsibility of administering an account for someone who’s no longer an employee, so most plans provide for immediate distribution of your money.
Another rule that the employer has to follow is to treat employees in a uniform and nondiscriminatory manner. In other words, your former employer has to handle your benefit distribution the same way it handled those of other employees who left under similar circumstances.
Leaving Money with Your Old Employer
Leaving your money in your old 401(k) plan may be a good temporary solution while you figure out your next step, but it’s probably not the best long-term solution.
Leaving the money in the 401(k) may have advantages for some investors because
- Some people don’t want to make new investment decisions. If you’re satisfied with your 401(k) investments, this strategy is fine. However, be aware that an employer can change the investments offered by the plan at any time. If your money is in your former employer’s 401(k), you have to go along with the change. During the switchover period, which can take several weeks or months, you won’t be able to access your account.
- Money in a 401(k) generally has more protection from creditors than that in an IRA should you declare personal bankruptcy.
Consider some of the drawbacks to leaving your money in your former employer’s 401(k):
- After you leave a company and are no longer an employee, you’ll be low in the pecking order for service if you request a distribution from the 401(k) plan or if you have questions or complaints. Companies can change a lot over time, including being acquired, restructured, or even going out of business. The level of support you receive as an ex-employee usually drops dramatically if this happens.
- While the money is in a former employer’s 401(k) plan, you can’t take a loan. (You have to pay back such a loan through payroll deductions.)
- You can no longer contribute to the old 401(k) plan, but you can rebalance the investments.
So, think long and hard before leaving your money when you change jobs.
Taking a Lump Sum
I would never advise this, but just so you know all your options, when you leave your employer, you can withdraw all the money in your 401(k) account in what’s called a lump-sum withdrawal. Surveys show that about one-third of participants who change jobs withdraw all the money in their 401(k) accounts. Often, they have small account balances and probably figure that it’s just not worth it to bother with a rollover.
Unless you have a serious financial need, cashing out the money and spending it is something you should avoid. Even if your account balance is small, it’s worth leaving the money alone. If you take cash, you’ll have to pay income tax on it. You’ll also owe the 10 percent early withdrawal penalty if you’re under 59½ when you leave your employer unless you qualify for one of very few exceptions.
Some people take a cash distribution and spend the money, figuring it’s such a small amount that it won’t matter. This is a mistake. An amount as small as $5,000 when you’re 25 can grow to $157,047 by the time you’re 65, assuming a 9 percent rate of return. That additional income can mean puttin’ up at the Ritz rather than puttin’ up a tent during your retirement travels.
What’s more, you wouldn’t even get the full $5,000. You’d get just $4,000 because your employer must withhold 20 percent for taxes.
While you’re still with your employer, the magic age for withdrawing money from the plan without a 10 percent early withdrawal penalty is 59½. This is also the magic age if you have an IRA. However, the IRS lets you avoid the penalty if you’re at least 55 when you leave your job (the job with the employer who sponsors your 401(k) plan). The reasoning is that if you lose your job at age 55 or older, it can be particularly hard to find a new one, so you may need the money. Imagine that — for once, the IRS gives you a break.
Taking Stock into Account
If you have stock in your employer’s company in your 401(k), you need to know a few things about taxation before you decide what to do with it.
One option is to convert the stock to cash and then transfer it along with your other 401(k) money into an IRA. This gives you an opportunity to diversify your investments by selling the stock (a single investment) and using the proceeds to buy a variety of investments. That’s good. However, if you’re willing to take on the increased risk of holding company stock outside your IRA, you can get an additional tax break on the company stock.
Here’s how this option works: If you take a distribution of the company stock from your 401(k) but you don’t roll it over into an IRA, you pay tax on the value of the stock at the time you acquired it — not at the time you withdraw it from the plan. This special provision of the tax law provides your first tax break, because the stock is most likely worth more now than when you received it. (Your employer is responsible for letting you know the total taxable value of the stock when you receive the distribution.)
Assume that you have $50,000 worth of company stock in your 401(k) when you take a distribution, but it was valued at $20,000 when you received it. At the time of your distribution, you receive $50,000 worth of stock but pay tax on only $20,000 of it. Later, when you sell the stock, your investment gain (whatever the stock is worth over $20,000) is taxed as a capital gain, a lower rate than the income tax rate. Another advantage is the fact that you don’t have to hold the stock for a one-year period in order for the gain to be taxed as a capital gain. If you don’t want the risk of holding onto the stock, sell it as soon as you want after receiving it.
If you hang on to the stock for a long time and still own it at the time of your death, your heirs will benefit. They’ll have to pay tax only on the gain that occurs after they receive the stock. Say it’s worth $100,000 when they get it, and they sell it at $110,000. They pay tax only on $10,000 — the difference between the value when they received it and the sale price. They never pay income tax or capital gains tax on the $50,000 gained while you held the stock.
This is a big tax break, but it’s only useful if you don’t need the money during your retirement years. You must also be willing to take on the higher investment risk of having a chunk of money invested in a single stock for a number of years.
There’s a high probability that the value of the stock will drop by 50 percent or more over a 20- to 30-year period regardless of how great a company it is. Committing to sell at some predetermined price — when the stock drops by 10 percent or more, for example — can provide some downside protection if you stick with that plan.