Avoiding Mistakes with Your 401k When Changing Jobs

What should you do with your old 401k retirement plan if you change jobs? Uncertainty and inaccurate advice can cause anxiety and catastrophic financial consequences.

As you may know, a 401k or other defined contribution plan is an excellent retirement savings vehicle. You can accumulate a substantial amount of money over many decades providing you let the money grow. With a traditional 401k, you also get the additional benefit of tax-deferred growth. With a Roth 401k, you forego the pre-tax advantage for tax-free withdrawals later in life when you take your money out.

Now suppose you have built up an impressive account balance over the years when suddenly you are faced with having to make a difficult decision. Every year, many people obtain new jobs or careers. Along with the excitement of a new transition comes apprehension and uncertainty over what to do with the old retirement plan. Discrepancies and inaccurate advice can cause anxiety for some and catastrophic financial consequences for others.

What you do can have a significant effect on your financial future. One mistake can cost thousands if not hundreds of thousands of dollars or more. The choice you make depends on your personal situation and whether your new employer offers a similar defined contribution plan.

Benefits of Tax Deferred Growth

If you have been investing money in your 401k plan for any length of time, you most definitely know about the benefits of tax-deferred growth. You may also be aware of the tax consequences and potential penalties on premature withdrawals if you take your money out early.

Taking Your Money Out

Taking your money out of your old retirement plan is the least favorable option. Here's why. Say you have an old account balance worth $200,000. If you take it all out in one lump sum to buy a house or whatever, you will owe taxes of approximately $50,000 to $60,000 in addition to a potential penalty of $20,000 leaving you with only $120,000 to $130,000. If you leave your current job prior to age 55, withdrawals from your 401k are subject to a ten-percent early withdrawal penalty. You should try to avoid using the money in your 401k for any reason other than for providing an income during retirement.

New Employer's Plan

If you do not cash it in, what else could you do with it? Maybe you have heard about the possibility of rolling your old 401k account over to your new employer's plan. Rolling over to a new employer's plan will preserve your account for retirement with the added benefit of continued tax-deferral. You should consider this option after careful consideration of other factors, such as the investments held outside of your retirement plan and the investment choices available with the new plan as well as your personal situation. One disadvantage with many 401k plans is the lack of quality investment choices within all asset classes. This makes it difficult to construct a well diversified portfolio consistent with every investors risk profile.

Old Employer's Plan

Depending on the options available in the new employer's plan, you may be inclined to leave your money in your old employer's plan. Letting it remain in the old plan is easy and certainly better than cashing out as described above. Maybe there are better investment options in the old plan than in the new one. The option to leave your money in your old plan or roll it into a new plan depends largely on the quality and quantity of options available in either 401k as compared to an IRA.

IRA Rollover

The advantages of rolling your old plan into an IRA are continued tax-deferral and a wider range of investment options. Having the entire universe of investment choices makes constructing diversified portfolios with the best mutual funds a much easier task. There are virtually no limitations. If you change jobs frequently, you may find yourself with several old employer accounts and/or IRAs. It can certainly become more difficult to manage many different retirement accounts making it easier to ruin a well diversified retirement plan.

Each option, leaving the money in the old 401k plan, rolling over to the new retirement plan or rolling into an IRA, has advantages and disadvantages. The right choice depends on each person's specific financial situation. A thorough review and understanding of all plan documentation and assistance from a qualified professional can help to make the decision easier.

This article may be reprinted with the following acknowledgment: ©2010 Bill Griffith Jr CFP. All Rights Reserved