How To Change Jobs Without Destroying Your 401(k) Plan

by Nancy Opiela

Congratulations, you just accepted a more exciting job with a higher salary. Before you celebrate too much, however, you should take some time to deal with your 401(k) plan. If you are under 59 ½ years old when you switch jobs, you need to play by some very specific rules to avoid losing a good chunk of your retirement nest egg to state and federal taxes and IRS penalties.

If you unsure how to deal with your 401(k) plan during the transition, you are not alone. While the Employee Benefit Research Institute (EBRI) of Washington, D.C. estimates that 27 million Americans manage a combined $1 trillion in 401(k) assets, many are not clear on ground rules if they switch jobs. In fact, nearly one quarter of those responding to a recent study by Neuwirth Research Inc. were unaware of the tax consequences and penalties associated with taking an early cash distribution from an employer-sponsored plan.

That's particularly significant when you consider that, according to the Bureau of National Affairs, 13% of the American workforce switched jobs in 1997 (not including layoffs) and that the Bureau of Labor Statistics reports that Americans hold an average of 8.6 jobs between the ages of 18 and 32.

Dee Lee, CFP, Harvard Financial Advisors, Harvard, Mass., conducts financial workshops for corporations and institutions across the country. Often, she finds herself called in by a human resource department after a layoff to educate departing employees on how to deal with their 401(k) plans. Along with Wayne G. Bogosian, Lee is also the author of The Complete Idiot's Guide to 401(k) Plans (Macmillan, 1998) .

"People just don't realize the amount of money they lose by raiding their 401(k) plans," Lee says. "If we're talking about someone in the 28% federal tax bracket and add Massachusetts' 6% tax and the 10% penalty, he or she will pocket just $5,600 from a $10,000 account."

While that might still seem like enough to furnish your living room or take a really great vacation, Lee urges those she works with to consider what might happen to the money if it was left to accumulate tax free until retirement. Explains Lee, "Let's assume, for example you are 35 at the time you pocket the $5,600. If we assume an annual rate of return on 10% and you left the $10,000 untouched until you reached age 65, you would have accumulated $174,000. Examples like this generally make people stop and think. When you take an early withdrawal from your 401(k), you sabotage your future."

Lee stresses that there are much wiser choices. First, if you have $5,000 in your current 401(k), you can just leave it where it is until you can withdraw it at age 59 1/2. The catch in choosing to do nothing, however, is that you can make no further contributions to the plan and you don't have access to it via a loan. You can, however, periodically rebalance your portfolio.

This option is an interesting temporary solution which buys you more time to evaluate the investment options of your new employer's 401(k) plan or to open a rollover IRA. This option is especially handy if your new employer imposes a waiting period before allowing you to participate in the company's 401(k) plan.

Of course there are other options and, as the assets in your 401(k0 plan are most likely the bulk of your retirement war chest, Lee says you should take the time to carefully consider each.

You can transfer your old 401(k) into your new employer's plan. The most important thing to remember here is to use a trustee to trustee transfer. In other words, the check cannot be made out to you. It must be issued from the trustee of your old plan to the trustee of your new plan. This is the only way to avoid having the IRS look at your transfer as an early distribution which would result in taxes owed and the 10% penalty.

Your second option is to open a rollover IRA at a brokerage, mutual fund company, etc. Why consider this option? Maybe your new employer doesn't have a plan or maybe you just don't like the investment choices your new plan offers. In fact, this is the option Lee favors because it gives you access to a greater number of investment choices. Again, the transfer must be made trustee to trustee to avoid taxes and penalties.

Lee also advises folks to keep the money in their rollover or conduit IRA separate from other IRAs they may own and not to make additional contributions into that account. This leaves the door open to one day roll your savings over again, perhaps into a 401(k) plan of a future employer. Lee also notes that you have to roll your old 401(k) into a traditional IRA because the rules for contributing to Roth IRAs are different than those governing 401(k) plans and traditional IRAs.

Another rollover catch is that you are allowed to roll only your pre-tax contributions. If you have made after-tax contributions to your old company's 401(k), you will have to take those in cash. However, because you have already paid income tax on this money, there is no penalty or tax due. Lee notes that it is possible, however, to rollover the interest you earned on your after-tax contributions. That takes some accounting work on the part of your plan sponsor, but is worth the effort.

Still confused? Need more advice? If your job change was prompted by a layoff, you might be able to talk your HR person into hiring a someone like Lee to come in and go over your options. Help is also available online from the fund companies. In fact, Fidelity will soon offer an on-line asset allocation tool developed especially for the growing rollover market. Developed by Strategic Advisors, the registered investment advisory arm of the company, the tool is designed for investors dealing with lump sum distributions or rollover assets. The new tool will guide investors through a step-by-step process to determine their time horizon, investment goals and risk tolerance. If you can't wait, Fidelity Rollover Express kit is available now through the company's web site www.fidelity.com.

Now, if you want time to evaluate your options and don't have $5,000 leaving the money put isn't an option. Rather than the trustee to trustee transfer to rollover new 401(k) or open a rollover IRA, you can ask that a check be made out to made out to you. This is an option Lee says you should avoid at all costs. Why? You have just 60 days to roll the money over to a tax-deferred account. If you don't, the IRS sees it as early distribution. You might think 60 days seems like a lot of time, but in a recent study EBRI found that of those taking early distribution more than 60% missed the 60 day deadline and forfeited some serious cash.

Other complication when the check is made out to you is that your employer must withhold 20% of the total amount for the IRS. That's the law. So, in order to roll the entire distribution amount over to tax-deferred account within the 60 days, you need that 20% from your pocket to supplement the check you received from your employer. Of course, if you do indeed roll the entire amount over into a tax-deferred account within 60 days, you'll get the 20% that was withheld back after you file your tax return. "It's amazing how many people will call me on day 64 and wonder if they can sneak something in. I tell them that's impossible," Lee says.

There are other issues that cause confusion when it's time to change jobs. If you have an outstanding loan on your 401(k) account you will have to pay it all back before you leave your job. If you don’t, the loan amount will be treated as an early distribution and you will have to pay a 10% penalty on that amount, plus federal, state and local taxes. Lee has seen employees unable to pay back the loan deplete the balance of their 401(k) to repay the loan. "You should take a loan from your 401(k) under only the most grave circumstances," she says.

You may also find yourself leaving money on the table of your old employer. If your company matches your contributions, you may need a certain number of years of service before you are 100% vested. That is, you may not be qualified to take all of your company’s contribution when you leave your job. Also note that if your old company matched your 401(k) contributions with company stock, you may have the choice of transferring cash or stock into a new plan. This can get complicated, so it's worth meeting with your HR person for more details.

Along with bringing new opportunities, your new job will also create a certain amount of upheaval and stress. It's important that during this period of transition, however, you don't just forget about your 401(k) -- your financial future depends on it.