When you’re leaving your job and possibly starting a new one, it’s easy to get wrapped up in the changes taking place in your life and forget about your 401(k). However, if you don’t follow the IRS’s 401(k) rollover rules, you may incur large penalties and lose a significant chunk of the hard-earned money you’ve set aside in your retirement fund.
Penalties Are Big
If you withdraw your money from your old employer’s retirement fund or move it into another non-qualified investment vehicle, such as a regular savings account, you may incur penalties, and the amount of money you receive may be far less than the balance of your retirement fund. First, your previous employer will withhold 20% for federal income taxes; additional funds may be withheld for state income taxes. Second, if you’re under 59½ years old, you’ll probably see an additional penalty applied. Consult your tax advisor.
As an example, if you have worked for 10 years and have $50,000 in your current 401(k) account, you could receive only $35,000 if are under 59½ years old and you elect to take a cash withdrawal rather than rolling over the funds into a qualified plan. Also, the money you receive could potentially bump you up into a higher income tax bracket, increasing the overall amount you are required to pay in income taxes.
Complying With 401(k) Rollover Rules
These rules are in place partly to motivate taxpayers to save for retirement. It is important to think seriously about taking money out of your retirement account before you reach 59½ years of age. When you leave your job, you have a number of options to manage your 401(k) savings without incurring a penalty. These options include:
- Leave your 401(k) with your old employer. This can be an easy short-term option. Your old employer is obligated to continue managing the money and provide communications just as they have in the past. You can change your mind later and move the money to your new employer or a different eligible account. However, don’t assume you can always follow this path.
- Make a 401(k) rollover to a plan with your new employer. You have 60 days to complete this transaction before penalties kick in. Contact your new employer’s benefits office when you’re hired so you can set up the rollover transaction on both ends without a last-minute rush.
- Invest in a non-employer retirement account, generally an IRA. You have many choices here: Roth or traditional, IRA savings or IRA CD. These options may be worth researching if you’re leaving a job and don’t yet know where you’ll eventually end up. This should be done within 60 days to avoid penalties.
At the end of the year you’ll receive a 1099-R statement saying that you’ve had a retirement fund distribution. When you reconcile your taxes be sure to show the appropriate destination for your money as a 401(k) rollover so the IRS doesn’t erroneously apply penalties. Check with a tax advisor if you have specific questions and to be sure you are aware of any changes in IRS rules.