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Hands Off The 401(k)

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Hewitt Associates, the same company that processes my company’s accounts payable, has performed a survey regarding 401(k)s. They discovered that almost half of workers leaving their jobs convert their 401(k)s to cash.

This is despite the fact that in addition to income tax, there is a steep penalty (10%) for cashing out the tax-deferred retirement savings. Most of those who cashed out their 401(k) had balances of less than $10,000, so we’re not talking about a large sum of money.

If I leave this company and move to another, I will roll my almost $20,000 in my 401(k) over to one offered by my new company if the investment choices are decent. Otherwise, I will leave my 401(k) where it is. I am currently investing enough to take full advantage of my company’s 4 percent match.

In addition, I’m investing the full amount ($4,000 this year) in a Roth IRA. I invest this money in the TIAA-Cref index fund. There was no minimum to open the account (with an automatic systematic investment) and the fees are very low.

Next year, my company will likely have an option for the new Roth 401(k), depending on the fees. This new investment option is similar to the Roth IRA as the money invested has already been taxed and the funds can grow unencumbered by additional taxes.

What about 401(k) loans? Well, I’ve mentioned this before and generally think it’s a bad idea. Although there’s debate as to whether your funds will be “taxed twice” once you pay your loan back and later take distributions (you’re paying the loan back with after tax money and you pay income tax on those same funds when you take the distribution) there are still negative points to consider.

You’ll lose whatever compounding growth on the money you take out for the loan, the loan could become due immediately in some circumstances, and there can be penalty fees if you can’t pay the loan back for some reason.

The best solution is to just let your funds stay in the 401(k) unless something better becomes available after leaving the job.

Updated February 6, 2012 and originally published July 25, 2005. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 5 comments }

avatar Neil

What about moving your 401k into a Rollover IRA if you switch jobs? That way, you can choose whatever investments you want – no restrictions.

avatar Luke Landes ♦127,373 (Platinum)

That would be a good solution if the new job doesn’t offer as good or as inexpensive funds as I could find privately.

avatar Steve

It may not apply much to people switching jobs, but the 10% penalty is only for taxpayers under 59 1/2 years old. On the other hand, 401k and tax-deferred IRA cashouts are obviously taxed at both the federal and state levels. Lesson? Plan!

avatar Jason Van Steenwyk

In most cases, you’re better off rolling over to some similar funds in an IRA. If you believe you will be in a higher tax bracket in retirement, you can also think about paying taxes now and converting to a Roth.

An IRA — particularly a Roth IRA, has important estate planning advantages and succession advantages over a 401(k). For example, where your heirs may be able to stretch an inherited IRA over their entire life expectancy, your 401(k) administrator may require your heirs to empty the account within five years – potentially costing your heirs decades of tax-deferred or tax-free growth.

Previously, if you were in a profession subject to frequent lawsuits (e.g., OB-GYNs, surgeons, etc.), or if you were worried about creditor protection, you stayed in a 401(k), since the 401(k) recieved additional creditor protection over the IRA (depending on state law).

Not so much any more – a recent court decision upheld the argument that IRA balances designed to provide reasonable retirement income also recieved a similar protection from creditors.

The only argument to stay in the 401(k), then, would be if you got exceptionally low fees in the 401(k) not available in an IRA (unlikely, if you index and know where to look), and were simply not worried about your heirs.

avatar Miss Money

Flexo:

Thanks for the advice. I am changing jobs in a week and wondering what to do with my 401K. I think I will either roll it over to the new 401K or leave it where it is. I was considering a Roth IRA but I don’t need to get the estate planning benefits just yet. Great advice!

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