A 401k is a great benefit, especially if your company matches a portion of it. Saving for retirement is extremely important, and a 401k allows you to do that pretty painlessly. But what happens to the money in it when you leave your job before retirement age, either voluntarily or due to a layoff?
Depending on your company’s policy and the amount in your account, you may be allowed to leave the money where it is. If you’re happy with your investment options and you won’t forget about the account, that can be something to consider.
But if you’re not, the other options are to cash it out or to roll it over to a different account somewhere else. This Rollover Chart from the IRS tells you what types of accounts the contents of a 401(k) (which is a qualified plan) can be rolled over into.
Two types of rollovers
There are two types of rollovers: direct and indirect. In a direct rollover, the company you used to work for sends a check made out directly to the custodian of your rollover account. Note that they may still send that check to you, but it won’t be made out to you. If that happens, it’ll be up to you to pass the check on in a timely manner to the company handling your investment. You have 60 days from the date you receive your distribution to roll it over.
In an indirect rollover, the check will be made out to you. This is not so good, for a couple of reasons. First, you’ll be tempted to spend it. (But don’t!) It’ll also have a mandatory 20% withholding for taxes taken out of it, which is bad because you’ll need replace that 20% yourself to make up the difference when you send the money on to its new home.
Otherwise the amount that was withheld for taxes will be counted as a withdrawal — which is taxed at your actual tax rate (which may then be higher than normal, because you’ll now have some extra income to be counted — that 20% that was withheld.). You’ll also be penalized on that amount. See this IRS tax topic for more information.
Which brings me to…
What not to do
Cashing your account out can be tempting — especially if you’re thinking of using your 401(k) for credit card debt, but it’s rarely a good choice. Remember, it may feel like “free” or “extra” money, but it’s definitely NOT. It’s money you spent a lot of time and effort earning. There’ll be taxes and penalties to pay as well if you cash it out. Who wants to pay a penalty?
As someone who went this route once, let me tell you it wasn’t worth it. I wish I had known better then, because I’d have been much, much better off letting it grow for retirement instead.
The next time I left a company, I went the rollover route instead. I did a direct rollover to an IRA. Much better to hang on to that money for when I’ll really need it. You know, when I retire either by choice or by circumstance.Posted in Retirement on 02.29.12 with 14 comments.