When Senior Editor Becky Cabaza left Bantam Books for Simon & Schuster in 1993, she didn't rush to transfer her 401(k) money into her new employer's plan. Thanks to previous job-hopping, she knew she should investigate her options before making a move. And it was a good thing she did. She discovered that not only did Simon & Schuster offer fewer investment choices than Bantam, but getting answers to her questions about the mutual funds in the plan proved near impossible. As a result, she decided to leave her account with Bantam. More recently, Simon & Schuster overhauled its retirement savings program. With greatly improved investment options and service, Cabaza is now contemplating rolling the Bantam money over.
If Cabaza learned one thing from moving around, it's that she shouldn't let her 401(k) get lost in the shuffle. Yet too often, the last thing job-hoppers think about are their 401(k) plans. Considering that these accounts represent the bulk of most people's retirement savings, managing these assets should be a top priority--not an afterthought.
TEMPTATION. When leaving a company, you have several ways to handle your 401(k): cash out, leave the account where it is, join your new employer's plan, or roll over the assets into a bank or brokerage IRA. Most people take the money and run--but that's by far the worst option. A 1995 Labor Dept. study found that 68% of people over age 40 and 84% of those under 40 fail to roll their retirement funds into another tax-deferred vehicle when they change jobs. The temptation to get your hands on a big wad of cash is understandable, but the taxes and penalties on early withdrawals should be enough to kill any desire. If you take a lump-sum distribution and are under age 59 1/2, the Internal Revenue Service will withhold 20% in anticipation of the income tax you'll have to pay--plus a 10% penalty on the proceeds.
Well before leaving your old job, you should find out whether your new employer has a 401(k) and will accept rollovers. If so, don't just dive into the new plan. Assess all your options, comparing the investment quality and flexibility of each. A well-designed plan offers a broad range of investments--from a conservative money-market fund to a menu of equity and bond funds--and the ability to transfer among them at no cost, says Julie Jason, author of You & Your 401(k) ($10, Fireside Books, 800 223-2336). It's important to read the plan summary, especially the sections on distributions and hardship withdrawals. Detailed, timely account statements and loan features are also key elements of a good plan.
Like Cabaza, you might find that your old plan offers a hard-to-beat combination of investment diversity, superior customer service, and other attributes. If your balance is more than $3,500, you're entitled to keep your account with your former employer until age 70 1/2, when you must begin taking mandatory minimum distributions. When making your decision, take into account any restrictions the old plan imposes on money left behind. "The rules will vary enormously," says Rich Koski, a principal at Buck Consultants in Secaucus, N.J. "Some companies will charge you an administrative fee or restrict your access to the account and any new investment options." Also keep in mind that you will no longer be able to make contributions to that particular account.
PENALTIES. One situation in which you might want to stay with the old 401(k) is if you have an outstanding loan against it and your former employer will let you continue repayment after you leave. However, most companies require that the loan be repaid in full immediately upon termination, so it's a good idea to investigate other repayment options well in advance. If you are unable to pay off the loan, the outstanding balance will be deducted from your account and subject to tax and penalty. For example, if your 401(k) totals $100,000 and you have an outstanding loan of $40,000, your employer will take $40,000 from the account and use it to satisfy the loan. The IRS then treats that money as a distribution on which you owe income tax--plus that 10% penalty if you're under age 59 1/2. The remaining $60,000 should be handled like any other 401(k) and left in the original account or rolled over into a new plan or IRA within 60 days.
A way around all this, if your new plan has a loan feature, is to arrange a short-term personal or home-equity loan before you change jobs, says David Wray, president of the Profit Sharing/401(k) Council of America in Chicago. You can use that money to pay off the 401(k) loan and roll over the full 401(k) balance into your new plan. Then, you can take out a loan against your new plan to pay off the outside financing.
But if both the old and new 401(k) plans are unsatisfactory, or you simply want more control over your investment choices, consider opening an IRA, says Manuel Bernardo, director of employee benefits at Deloitte & Touche in Stamford, Conn. An IRA is the only other way to maintain the tax-deferred benefits of a 401(k) and avoid taxes and penalty.
The major advantage of an IRA is flexibility. "With the advent of no-transaction-fee mutual funds and no-fee IRA programs, you can get access to thousands of funds and 24-hour service," says Will Bashan, president of Cigna Financial Partners in Hartford.
Each time Curtis Shaw, 47, got a new job, he rolled over his 401(k) money into an IRA. "I'd rather be able to direct the investment myself than be limited to the options any new plan provided," says Shaw, counsel for Nynex Corp. in White Plains, N.Y. He has invested his IRA in everything from zero-coupon bonds to individual stocks.
While rollover IRAs offer more investment selections than a 401(k), you lose the ability to make additional contributions (except for rollovers from other qualified plans), borrow against your account, or protect your assets. "If you have existing debts or potential exposure to lawsuits, a 401(k) offers greater protection from creditors' claims than an IRA," says Kenneth Brier, a tax attorney with Sherburne, Powers & Needham in Boston.
When considering an IRA rollover, beware of consultants bearing bad advice. Employers frequently offer departing workers financial-education seminars, which all too often become forums for investment sales pitches. At one such gathering, a financial adviser solicited a 56-year-old man with a $560,000 401(k) and convinced him to put all the money in a "no-load" variable annuity. While it sounded good in theory, the man didn't realize he would be paying an additional 1% per year in fees for an extra layer of tax deferral that he didn't need.
COSTLY MISTAKE. If you choose an IRA, the first step is to set up a segregated account for tax purposes, says Wendy Blank, a financial planner with Blank Financial Group in New York. As long as you do not mix your rollover account with other qualified-plan assets, you'll still be able to bring that money into your new company's 401(k) plan later. Then, you'll need to instruct the 401(k) administrator to transfer assets directly to your new IRA instead of cutting you a check. If you receive a check, the company must withhold 20% of the money. To continue tax-deferral benefits, you will need to deposit the check with your IRA custodian within 60 days, says Jason, the author. And you'll need to add the 20% that was withheld into the IRA or that 20% will be considered a distribution subject to taxes and the 10% early-withdrawal penalty. As long as you make the account whole, the IRS will refund the withheld 20%.
Now that 401(k) plans have been around for nearly two decades, participants who contribute regularly are astonished by how much they have managed to save. So if you change jobs and don't carefully consider how to handle your 401(k) money, you could be setting yourself up for a costly mistake.