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June, 2006 Tax Tip

What To Do With Your 401(k) When You Change Jobs

If you have money vested in a 401(k) plan and you change jobs, you are faced with several decisions as to what to do. You can leave the money in the former employer's plan, if permitted; you can transfer the money to your new employer's plan, assuming there is one; you can transfer the money to an IRA account; or you can take a distribution. The last option should be avoided if you have not attained age 59, unless you need money for living expenses, since the amount distributed is subject to both income tax and an additional 10% penalty tax.

Keeping the Money Where It Is

Many employers allow individuals who change employment to leave money in the plan.?There is a section in the tax code that provides that an employer generally cannot force an employee to take a distribution unless his or her balance in the plan is $5,000 or less. Therefore, if you are happy with the investment choices and returns provided in the plan you probably would want to keep your money there. Also, many 401(k) plans permit an individual to borrow money from the plan. Accordingly, leaving the money in the plan, rather than rolling it into an IRA, would allow you to take advantage of this should the need arise. Taking the money from an IRA without tax consequences is far more restrictive.

There are also some disadvantages to consider in leaving the money in the plan. Some plans consist entirely or largely of the employer's stock. With everything in one investment, there is a risk of losing a good portion of your investment if there is a decline in the value of the stock. That is why financial advisors strongly recommend diversification of your investment.

Transferring to New Employer's Plan

This option is advantageous if the investment choices offered by the new plan are better than those offered in the prior employer's plan. It also preserves the opportunity to take a loan from the plan if the need arises, assuming the new plan permits borrowing. There are two ways the transfer can be done. You can take a distribution from the old plan and roll it over into the new plan within 60 days or, if the new plan permits it, the transfer can be made trustee to trustee, referred to as a direct rollover. The latter is almost always preferable because the IRS requires that 20% of the amount distributed be withheld.? Thus, you will need to wait until you file your tax return to get the money back.

Observation: If you are making quarterly estimated tax payments, you can reduce the payments by the amount withheld to essentially get the money back sooner.

Transferring to an IRA

There are some interesting possibilities presented by this option. If you choose a self-directed IRA account, it would offer the same diversity and even more control over your investments than were offered in your 401(k) account. In a self-directed IRA, you can use the money to purchase almost any investment product that you want, such as stock, bonds, mutual funds, and a potential bonanza  real estate. You can pay professionals to set up the IRA and manage it for you.? You will, however, lose the availability of taking loans, as they are not permitted from IRA's.

As with the transfer to the new employer plan, you should make a direct rollover (trustee to trustee) transfer. Your IRA custodian would contact your former employer and request that the money be transferred directly to the financial institution. If at all possible you want to avoid first taking a distribution and then transferring the money to the IRA within 60 days. The reason for this is that you are required to transfer the entire amount that was distributed from your 401(k) into your IRA. Therefore, not only would you have the 20% withholding, but you would also have to come up with the amount withheld to transfer into the IRA to satisfy the rollover requirement.


What if you can?t decide right away between transferring the money to the new plan or to an IRA, or if you don't yet know who the new employer will be? An IRA can be used as a temporary holding account until you decide. If you ultimately decide to transfer to the new employer plan, you can have the trustee of your IRA transfer the money to the new employer plan. It is highly advisable to set up a separate IRA account? for the 401(k) money so that these types of transfers can be made without problems.


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