Millions of workers will leave their jobs this year through career moves, layoffs or retirement, and many of them
will face an important decision about what to do with their
retirement nest eggs.
Should those savings fly the coop, too?
Several options are available for those participating in
employer-sponsored retirement plans like the 401(k): They can stay
invested with their former employer; transfer to a new employer's
plan; roll it over into an Individual Retirement Account; or take a
Many people aren't aware of these options and their tax
consequences, so the most common move has been to take the money
and run, which can be a costly strategy.
A study released in 1997 by the Employee Benefits Research
Institute found that 60 percent of job changers took cash payments
from their tax-deferred 401(k)s. Only 7 percent rolled the payouts
into another plan; 33 percent into an IRA.
"So many people just take the cash and spend it not realizing
the tax ramifications of it," said Ed Slott, a Rockville Centre,
N.Y., accountant who publishes a monthly retirement benefits
newsletter. "They're probably only going to keep 60 percent of it
(after taxes), but they're spending 100 percent of it."
Lump sum distributions are subject to at least a 20 percent
withholding for federal taxes, plus those younger than 59 1/2, may owe
an additional 10 percent penalty tax for early withdrawal.
Rollovers, on the other hand, are tax free as long as the money is
transferred to a tax-deferred account like another 401(k) or IRA.
There are other tax traps to watch out for.
Those who opt to roll over their retirement savings into an IRA
must keep a watchful eye on the calendar. Individuals with 401(k)
withdrawal in hand have 60 days to deposit the entire check into
another qualified tax-sheltered account or face tax penalties.
And those planning to temporarily park their funds in an IRA
before transferring them into a new 401(k) must be careful how they
handle this transaction.
"It has to be a brand new IRA, not an existing IRA ... or it
can't be done," Slott said.
He noted that individuals can't make additional contributions to
this conduit account because it will be considered "tainted," and
therefore, can't be transferred to a new 401(k).
Also, those who want to roll their 401(k) money into a new
tax-free Roth IRA must first transfer their funds into a new
traditional IRA, then convert some or all of it to the Roth.
They'll have to pay an upfront conversion tax.
Robert B. Wolfe, a financial adviser from Wilmington, Del.,
urges individuals to contact the benefits departments of both their
old and new companies before making any decisions since each
employer's policy may differ.
Some employers will let former employees remain in their plan,
while others won't; some employers require new employees to work
for a certain length of time before participating in their 401(k),
while other's don't.
"The (former) company may give you between 60 days and up to
one year after you leave to reinvest ... . If you choose not to
reinvest, you may have to wait until you are 65 years old to get
access to your retirement money," Wolfe noted in his January
"Other companies let you obtain your distribution at any time
once you terminate employment."
The advantage of staying put in a former employer's plan is that
taxes and penalties are avoided while earnings continue to grow
tax-deferred. But investment options may be limited, especially
when compared with those available in an IRA.
Slott advises against sticking with a former employer's 401(k).
"I find that ex-employers are not that concerned about
ex-employees," he said.