Changing jobs creates 401(k) decision

WASHINGTON -- Summer is often a time of transition.

Many employees switch jobs during the summer and many often wonder: Should I let the money I've accumulated in my company retirement plan stay in the old plan?

One participant in my online chat recently wrote: "I have $20,000 that I left in my 401(k) from a former employer. It's still doing pretty well but I always hear that you should move it into an IRA or roll it into the 401(k) with the new employer."

This is a good example of why it's important to question advice that appears universally accepted. Often the information is wrong or incomplete -- sometimes because it's coming from an individual or industry that stands to profit from the advice.

If you have money in a tax-deferred retirement plan and you're moving on to another job, you have several options for the money in that account. You may be able to leave it in the old 401(k) plan, roll it into your new employer's plan if allowed, put it into an Individual Retirement Account or take the cash.

Let me start with the last option -- cashing out. It's almost always the most idiotic choice. And yet many employees do cash out, according to Hewitt Associates, a human resources services firm.

In a study of nearly 200,000 workers, Hewitt found that 45 percent of people who left a job opted to cash out their 401(k) plans.

Just look at how much you lose if you cash out. The money is subject to federal and state income taxes. Except under some very limited circumstances, if you cash out before age 59½, you're penalized another 10 percent. At the highest tax federal tax bracket, you could lose more than 45 percent of the money you've accumulated for retirement.

Another option is to roll the money into your new employer's plan. Tax-law changes now allow employees to take their retirement plans with them, even if it's not the same type of plan.

Many employers make you wait a certain period of time before you can enroll in their 401(k) plan. While waiting, you can leave the money where it is. If your account has more than $5,000, your former employer can't kick you out of the company sponsored plan. To stop employees with small balances from cashing out, a law change in 2005 requires employers to automatically roll over accounts between $1,000 and $5,000 into an IRA when workers leave, unless they choose another option.

Leaving the money in the old plan may also make sense if you're happy with the investment options or returns you're getting.

Finally, you can transfer the money into an IRA. For some, this may be the best choice, especially if your former employer's plan has limited investment options. With a rollover IRA you decide how to invest the money.

If you choose this last option, make sure the money is transferred directly from the old plan to the new IRA. If your employer makes the check payable to you, the company is required to withhold 20 percent of the money for tax purposes.

Unfortunately, this last point is where so many people get in trouble with the IRS. It's important to know that if your employer sends you a check for the remaining 80 percent, you are responsible for making up the missing 20 percent to avoid the penalty for taking a nonqualified distribution. If you replace the 20 percent, you get it back when you file your next federal tax return. If you can't make up the 20 percent, it is included in your gross taxable income.

If you fail to roll over the money within 60 days, you're subject to the 10 percent penalty for an early withdrawal. I can't tell you how many people get caught with a nasty tax bite because they didn't do the rollover in time.

© 2007, The Washington Post Co.