Last Updated: July 13, 2009
If you recently left your employer, you're probably wondering what to do with your 401(k) plan. Typically, you have a few options. You could take a lump-sum distribution and roll that money into an individual retirement account (IRA). You could — though taxes would likely be due — take a lump-sum distribution and use the money for spending or paying off bills. Or, you may be able to leave the money in your former employer's retirement account or transfer it to your new employer's retirement plan.
Many American workers tend to typically take a lump-sum distribution, according to recent research by the Employee Benefit Research Institute (EBRI), "As of 2006, 16.2 million workers had taken a lump-sum distribution of their retirement plan assets," according to an EBRI release. "The average amount of these distributions was $32,219 and the median (mid-point) amount was $10,000. Almost half of these distributions were for less than $10,000, and 22.7 percent were received from 2004 through 2006."
According to EBRI, through 2006, "almost half (47.3 percent) of those taking a lump-sum distribution used at least some portion of the money for tax-qualified savings, while 16.9 percent used at least some portion of it for consumption. The other most prevalent uses were buying a home, paying off debt, or starting a business."
So, what should you do with your retirement account if you've left your employer?
"Do a direct rollover either to an IRA or to a new company plan instead of taking the money," suggests FPA member, Joseph R. Hearn, vice president at Teckmeyer Financial Services, LLC. "I'm always surprised at the amount of people that leave their job and then use their 401(k) account as a de-facto severance package," he said. "Doing so not only puts a dent in their retirement savings, but also results in an abundance of taxes and penalties. Unfortunately, a lot of people make that decision without knowing the consequences."
In short, here are your choices, and the costs and benefits associated with those choices:
- Roll it over to an IRA. According to Hearn, this allows you to continue to defer taxes, and it usually gives you more investment options and more control.
- Transfer to a plan at your new company. This too continues the tax deferral, but Hearn said there may be a waiting period to get into the new plan and they'll probably have fewer choices than the rollover IRA.
- Keep your money in the old plan. Again, the tax deferral continues, but there are some drawbacks, said Hearn. You wouldn't be able to make new contributions to your former plan. You would lose some of the benefits of compounding because your retirement accounts aren't consolidated. And, the number of investment choices usually isn't as great as with an IRA rollover. According to the U.S. Dept. of Labor's Employee Benefits Security Administration: "If your account balance is less than $5,000 when you leave the employer, the plan can make an immediate distribution without your consent. If this distribution is more than $1,000, the plan must automatically roll the funds into an IRA it selects, unless you elect to receive a lump sum payment or to roll it over into an IRA you choose. The plan must first send you a notice allowing you to make other arrangements, and it must follow rules regarding what type of IRA can be used (i.e. it cannot combine the distribution with savings you have deposited directly in an IRA). Rollovers must be made to an entity that is qualified to offer individual retirement plans. Also, the rollover IRA must have investments designed to preserve principal. The IRA provider may not charge more in fees and expenses for such plans than it would to its other individual retirement plan customers.
- Cash out. This is usually the worst option, especially if you are under age 59½, said Hearn. According to the Employee Benefits Security Administration, if you elect a lump sum payment and do not transfer the money to another retirement account (employer plan or IRA other than a Roth IRA), you will owe a tax penalty if you are under age 59½ and do not meet certain exceptions.