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You're changing jobs and you've got
several thousand dollars in your former employer's 401(k) plan. What to do?
It looks like that money could just about
cover credit card bills you've built up. Should you wipe the slate clean by paying those
bills, and start fresh with a new job and outlook? "No! No! No!," say retirement
experts.
With people reportedly changing jobs about every five years
or so, on average, it's apparent that many workers, at one time or another, are going to
have to decide what to do with their 401(k) money when they change jobs.
Regrettably, most are not making the smart choice.
Financial planners are united on this one point: Leave your
retirement funds, no matter how small, within tax-deferred savings accounts.
Yet, this advice is falling on deaf ears. A recent study
shows American workers are cashing out of their 401(k) plans at near-record rates.
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Sixty-eight percent of employees opted to
take a cash payout from their 401(k) plan when changing jobs, according to a recent Hewitt
Associates study.
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Sixty-eight percent of employees opted to take a cash
payout from their 401(k) plan when changing jobs, according to a Hewitt Associates study.
Only one-third of workers roll their balances into an IRA or a new employer's plan.
By understanding more about how penalty rules and money
compounding work, and by adopting a retirement strategy, you can reduce your chances of
having to work during your retirement.
The Lump-sum Psychology
When workers change jobs, the company they're leaving
commonly tells them that they should do something with their retirement money. The
question is, what?
Few employers provide advice to workers about how to
preserve their retirement nest egg. Many workers feel the need to pull the money out of
the plan. If a worker is struggling to pay credit-card bills, the retirement lump sum may
seem like a windfall.
"A lot of people ... say 'here's a down payment on my
next car,'" said Trisha Brambley, president of Resources for Retirement Plans, Inc.
"It's overwhelmingly tempting to take that money."
Anecdotal evidence shows that many folks use their
retirement nest eggs to pay off credit-card bills, and rationalize that they're doing this
so they can start fresh.
"Unfortunately, they end up back in the same problem
in a year or two," said Ted Benna, creator of the first 401(k) plan and president of
the 401(k) Association.
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"It's overwhelmingly tempting to
take that money."
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| —Trisha
Brambley, president of Resources for Retirement Plans, Inc. |
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The best solution is to change money-management habits.
"Throw your credit cards away," urges Benna. "The problem is ... using them
to buy things you aren't able to pay for."
The Big Tax Bite
Many workers don't realize they pay a heavy price if they
take the money out of the tax-deferred account. Initially, they are subject to high taxes
and penalties, and later to a reduced retirement balance.
Phillip Cook, a certified financial planner in Torrance,
Calif., says 401(k) money is some of the most "expensive" money you can tap for
day-to-day use. "Make (your retirement account) the last place you go to get
money," he said.
Let's look at how costly it can be.
The first cost is the 10 percent penalty for withdrawing
money before you're 59ý. (In effect, for a 401(k) plan, this penalty doesn't apply if you
leave your job once you are 55.) This penalty may be waived if you're making an
IRS-approved hardship withdrawal.
Next are the income taxes. Any withdrawal is added to your
annual income, and this could push you into a higher tax bracket.
Suppose you're 35 years old, single, earn $35,000 annually
(putting you in the 28 percent tax bracket), and have $10,000 in your 401(k) plan. Further
suppose you decide, when you change jobs, that you want to cash out the $10,000 from your
old employer's 401(k) plan.
When you take the money, you'll have to pay a $1,000 early
withdrawal penalty and $2,800 in income taxes. This leaves you with a balance of $6,200, a
nearly 40 percent reduction of your original principal.
Now, suppose you're 35 years old, married, and have $10,000
in your 401(k). You and your wife together earn $105,000 annually, putting you into the 31
percent tax bracket. Again, assume when you change jobs you decide to cash out of your
401(k) plan.
This time, you still pay a 10 percent early withdrawal
penalty of $1,000, plus $3,100 in income taxes, leaving you with only $5,900.
Lost Opportunity
There's an old saying that goes, "It takes money to
make money." What many workers fail to realize is that even a small amount of money,
if given enough time to grow through compounding, can become quite large.
The Hewitt study also found that the smaller a worker's
account balance, the more likely he or she will cash out.
Benna offers an example to show how much your money will be
worth at retirement.
Take the earlier example of a 35-year-old with a $10,000
lump sum in his or her 401(k) account. Let's assume that money earns a 9 percent annual
return. In 30 years, that money would grow to $132,677, if no further contributions were
made.
If you withdrew the $10,000 at age 35, you would have to
contribute $973 a year for 30 years to end up with the same $132,677 balance, Benna said.
The chart below shows the missed opportunity for workers of
various ages who withdraw a $10,000 nest egg.
Stay in Your Protective Envelope
So, the issue is, how do you keep your retirement nest egg
safe? You have several options:
- You could roll it into a new employer's plan. One
good reason for doing this is so that you can consolidate your accounts, advises David
Bennett, certified financial planner and owner of Total Financial Concepts in Los Angeles.
Further, rolling into a new employer's 401(k) will preserve your ability to take a loan
against the balance. However, some plans do not allow rollovers.
- You can roll the money into an IRA. If you roll it
into a new IRA, and don't make any new contributions to that IRA, you will be able to
eventually roll the money into a 401(k) plan of a future employer. This is sometimes known
as a "conduit" or "rollover" IRA, and it is a good idea because it
lets you keep your options open. You can also roll the money into an IRA that you
contribute to, but this means you will not be able to roll it into a new 401(k) plan one
day. The best way to do either one of these rollovers is through a
"trustee-to-trustee transfer." This means you instruct your company to transfer
the account balance directly to the financial institution that houses your IRA.
- If your 401(k) balance is greater than $5,000, you could leave
the money in your former employer's plan. Perhaps you like the investment choices the
plan offered. However, the drawback is that you can't take a loan on this money, and some
employers may only allow limited withdrawals. Finally, the employer could change the
investment mix.
Envelope for Retirees
If you retire when you're 55 or older, you should be able
to get at your 401(k) money without paying an early withdrawal penalty. Read Are You Ready to
Retire Early? for more strategies on taking early retirement.
Some employers may require you to take a lump-sum
distribution, while others may permit you to make periodic withdrawals. You should check
with your human resources department or read your plan document to find out your plan's
rules.
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"Make (your retirement account)
the last place you go to get money."
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| —Phillip Cook,
certified financial planner in Torrance, Calif. |
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Regardless, if you want to avoid a huge tax bill, don't
take a lump-sum distribution, Bennett urges. "If you take it piecemeal, you only pay
the taxes at the time" you actually withdraw the money, he added.
Here's how it works. If you had a $1 million nest egg and
took it in a lump sum, you would have to tell the IRS you received $1 million in annual
income and you would have to pay $400,000 in income tax.
If you roll your money from the 401(k) plan into an IRA
using a trustee-to-trustee transfer, you won't have to pay taxes on that money. Then, you
can withdraw money, as you need it, and pay the lower tax rate at that time. |
