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Rolling over a 401(k) plan

September 07, 2011

There’s a line from an old rock ’n’ roll song that goes, “It’s better to burn out than to fade away.” When it comes to managing a 401(k) plan from a previous employer, one could change this lyric to, “It’s better to roll it over than to let it fade away in your memory.” Although not nearly as catchy, that’s generally sound advice.

Good targets

The main reason to roll over a previously established 401(k) is to simplify and consolidate the management of your retirement accounts. There are two good “targets” for a rollover: a new 401(k) or an IRA. If you don’t have an IRA and intend to participate in your new employer’s 401(k), rolling over your account into the new 401(k) is likely the simpler option.

But, if you want to own a specific mutual fund or security, an IRA provides more flexibility. An IRA custodian can help you choose the funds or securities you want, while a 401(k) limits you to the options your employer chooses to make available.

Of course, IRAs have their downsides. They typically charge modest administrative fees, while employers typically pick up 401(k) plan fees — though more are starting to pass some fees along to employees. Also, IRAs can’t allow loans, while 401(k) plans can (and many do). On the other hand, IRAs offer more opportunities for penalty-free withdrawals before age 59 1/2.

Direct or indirect

Whether you decide to roll over your account into your new employer’s 401(k) or an IRA, a “direct” rollover is almost always best.

Under this method, you never take possession of your funds. The administrator of your old 401(k) plan transfers your assets directly to your new 401(k) administrator or IRA custodian. In some cases, the check will first be sent to you to hand over to the new administrator or custodian. As long as the check isn’t made out to you personally, this is still considered a direct rollover.

By contrast, an “indirect” rollover entails your taking personal possession of your assets before rolling them over. It’s important to note that if you don’t redeposit the funds in your new 401(k) or your IRA within 60 days, it’s considered a distribution, and you’ll owe income taxes and, if you haven’t reached age 59 1/2, generally an additional 10% early withdrawal penalty.

What’s more, your old employer will be required to withhold 20% of the distributed amount as a down payment on potential federal income taxes. (You may be able to receive a refund of the amount withheld when you file your tax return, depending on your overall tax liability for the year.)

When you do your rollover, you’ll want to replace the withheld amount with funds from another source. Otherwise, even if you meet the 60-day deadline, you’ll owe income tax — and perhaps the 10% penalty — on the amount withheld.

Risky move

There may be a few instances, such as a medical or financial emergency, when you need to consider cashing out your 401(k) instead of rolling it over. But doing so is risky.

Tapping your retirement funds too early accelerates tax liability and can subject you to stiff penalties. You’ll owe federal income taxes — and, depending on where you live, maybe state and local income taxes — on the withdrawal, as well as potentially the 10% early withdrawal penalty. (One key exception: If you’re age 55 or older when you leave your job, you may be exempt from this penalty. Ask your tax adviser for details on this and other exceptions.)

In addition, by withdrawing funds you’ll not only reduce the size of your nest egg, but also lose its future tax-deferred growth potential. The combined effect of significant taxes and penalties and lost appreciation potential going forward can be enormous, so it is best to check with your tax adviser before withdrawing funds.

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