Leaving Your Job? Don't Forget Your 401(k)

Nearly half of U.S. employees cash out of their 401(k) accounts when they leave their jobs, according to a recent survey by Hewitt Associates. Hewitt reports that the figure--46%--has remained virtually unchanged since 2005, despite attempts to raise awareness about the penalties of taking money out early.

The study found that young workers were the most likely to take money out of their accounts, with 60% of workers in their 20s cashing out. But the numbers aren't much better for those who have been in the workplace longer--47% of those in their 30s and 43% of those in their 40s cash out their retirement savings when they leave their jobs. The penalties for early cash-outs are severe--you will owe income taxes on the entire amount, and those cashing out before age 59 1/2 face an additional 10% penalty.

Evaluate Your Options
Deciding what to do with your 401(k) when you leave your job can be tricky and depends upon your personal situation. Your options include leaving it with your old company or rolling the account over to either your new company's 401(k) or an Individual Retirement Account (IRA). Whatever you do, do not take your money out! Not only are you short-shrifting your retirement years, but you'll also pay taxes and a penalty that could amount to close to half of your account balance.

What Happens If You Don't Do Anything?
You can usually leave your account where it is, but you typically cannot continue to make contributions and you are limited to the investments included in the plan. You will also probably have to pay administrative costs associated with the plan that wouldn't exist if you went into an IRA. Some plan providers will not allow you to leave your money if your balance is less than $5,000--a constraint that may explain the high rate of cashing out for those with low balances.

Leaving your 401(k) as-is could make sense if you are happy with your fund lineup, and if you have a solid selection of low-cost options. Many 401(k)s give you access to institutional-priced funds that you could not get as an individual retail investor.

Should You Rollover?
Rolling your account over to your new company plan is a reasonable way to go if you are happy with the new plan's investment options and you are not paying additional administrative costs for the plan. The big advantage of this option is consolidation: with all of your retirement assets in one account, it is easier to look at them as a cohesive whole.

Rolling over to an IRA gives you the most flexibility, however. In an IRA, you can choose your investments without being limited to those selected by your company, and future job changes will not affect your account. Importantly, you won't have to pay administrative costs in an IRA, unlike in many 401(k)s. You can also continue contributing to the IRA in addition to your new company's 401(k). 

If you decide on an IRA, there are several things to consider. These are the key steps of a 401(k) to IRA rollover:

1. Decide between a traditional IRA and a Roth IRA. Generally, you want a Roth if you expect your taxes to be higher at retirement than they are now. See this article for an overview of the differences and for help deciding which is right for you. If you have a traditional 401(k), it is easiest to roll over to a traditional IRA, since both accounts deal with pre-tax dollars that will be taxed when you withdraw your money in retirement. Similarly, a Roth 401(k) is most simply converted to a Roth IRA, as they both deal with after-tax dollars. If you roll over from a standard 401(k) to a Roth IRA, you will owe taxes on the amount you roll over (but you won't have to pay taxes on your withdrawals in retirement, and your earnings will grow tax-free). Income limits previously prevented those earning above a certain threshold from rolling over into a Roth IRA, but these restrictions are lifted for 2010, which could provide a unique opportunity for those with higher incomes. Read Morningstar Director of Personal Finance Christine Benz's article for more on 2010 Roth IRA conversions.

2. Choose an IRA provider. You can open an IRA either at a brokerage (such as E*Trade or Scottrade) or with a fund company (such as Vanguard, Fidelity, or Dodge & Cox). Look at annual fees, ease of account access, and investment options. 

3. Contact the company for the new IRA. Do this before you contact your old plan provider. The new company has an interest in helping you complete the transaction as painlessly as possible and can help you navigate the process, while your old provider might drag its feet. The exact rollover process varies by company. For some, you open an account and then contact your old provider. For others, you must first contact your old provider to submit forms before you can open your account.

4. Tackle the paperwork. Unfortunately, there will be a good deal of it, and it can be confusing and time consuming. Call the companies (new or old, depending on the form) if you have questions while filling out the paperwork--you don't want to risk delays from mistakes. When choosing the type of rollover, make sure you choose "direct rollover" so that the money transfers directly to the new provider rather than passing through your hands. Direct rollovers are simpler and less likely to expose you to taxes.

5. Follow Up. Double check to ensure all necessary forms have been received and there is nothing left to do on your end. If your funds are not transferred within the promised timeframe, make calls to your new and old providers to see if there is an issue.

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