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David Bach The Automatic Millionaire

David Bach, The Automatic Millionaire

The Five Biggest 401(k) Rollover Mistakes

by David Bach

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Posted on Monday, October 8, 2007, 12:00AM

A couple of weeks ago, I invited readers to take part in my 401(k) savings challenge, and promised to keep the momentum going with more articles about making the most of your retirement plans.

401(k) Rollovers Uncovered

One of the topics many of you wanted to learn more about is how to make smart rollover decisions when changing jobs. Well, you're not alone. According to consultant Deloitte's most recent 401(k) Benchmarking Survey, 22 percent of employers surveyed revealed that their employees find rollovers to be the most confusing part of their retirement plan.

"Rollover" is the term used to describe moving money from one type of tax-advantaged account, like your 401(k) plan, to another, such as an individual retirement account (IRA) or a different 401(k) plan at your next job.

The goal here is simply to ensure that your money continues to grow tax-deferred and that the government is aware of its status. Otherwise, you're likely to get hit with a tax bill for funds you didn't want to receive until retirement, and possibly an additional penalty.

The Five Pitfalls

Here are five of the biggest 401(k) mistakes people make when changing jobs, and my advice about how to avoid making them yourself:

1. Cashing out.

The last thing you should do is tap into your retirement savings simply because you're changing jobs and you can. Yet according to Hewitt Associates, 45 percent of employees do this. What's worse is that 69 percent of employees between ages 20 and 29 cash out -- and this is the group with the most to gain from long-term compounding.

Let's not forget that this money has been earmarked for retirement, and that's why you get tax advantages. But when you break your agreement with Uncle Sam, he wants his payback. Not only will you be required to pay ordinary income taxes on any before-tax contributions and investment earnings you receive, you'll also have to fork over an additional 10 percent tax penalty if you're under 55 (if your money is already in an IRA, the tax penalty applies until you reach 59-1/2).

To drive the point home, consider what happens at age 25 if you cash out a $5,000 balance. You'd receive a net amount of only $3,100 -- $5,000 minus 28 percent ordinary income tax ($1,400) and the 10 percent early-withdrawal penalty ($500). However, if you rolled over your original $5,000 and kept it invested until age 65 (assuming 8 percent annualized earnings), you could end up with more than $108,000 at retirement.

2. Leaving your money behind.

If you leave your job for a new one, don't leave your 401(k) money with your former employer. Why? When you leave a 401(k) balance behind, you run the risk of giving up control of your investments.

If you're out of touch with your old plan and they change mutual fund providers (from a Fidelity 401(k) plan to a Vanguard 401(k) plan, say, which is something that happens all the time), not only can your money be frozen during the transition, but it may default to the new plan's low-yielding money market fund or other investments you might not like.

It's also important to note here that just because your new employer offers a 401(k) plan doesn't mean you shouldn't consider rolling over your old account into an IRA instead. IRAs often offer you much more flexibility than a 401(k) plan with regard to investments, withdrawal options, and alternatives for your beneficiaries.

Employers aren't required to keep you on their books if you have a 401(k) balance under $5,000. However, rather than cashing you out, they must at least establish an IRA rollover for you with this money. If your balance is less than $1,000, you may still be cashed out of a former employer's plan.

Another strong argument for taking your money with you is that people simply tend to forget about old plans -- or worse, they die and their beneficiaries have no idea that the account even exists.

3. Not taking the "direct" route.

There are generally two ways to go about requesting a rollover: You can set up a direct rollover, where the funds are electronically transferred to a new plan or account you're establishing (or a check is drawn in their name). Or you can receive payment within a 60-day window in which to roll over the money.

The latter may sound like an attractive option to temporarily splash around in your retirement pool if you have short-term cash-flow needs. However, there are too many things that make it unattractive.

For one thing, you won't get a check for the full amount of your account balance. Employers are required to withhold 20 percent of the gross amount as a prepayment of your income taxes if the check is made out directly to you. So, if you're trying to roll over $10,000, you're only going to get a check for $8,000 -- and that means you have two months to come up with the additional $2,000. (You'll be reimbursed the $2,000 when you file your federal income taxes.)

If you miss the deadline, then the whole amount is considered a taxable distribution. You'll have to add another $10,000 onto your taxable income for the year and pay income tax on that amount. If you're under 55, you also get hit with the 10 percent early-withdrawal penalty.

So, if at all possible, avoid ever having a rollover check made out to you. Some employers may only offer you the option of sending the check to you, but make sure to have it made out to your new financial institution -- so there are no withholding requirements -- with an "FBO" ("for the benefit of") naming you. For instance, my check might be made out to "Morgan Stanley IRA Rollover FBO David Bach."

There's more about the rules for rollovers here.

4. Making hasty decisions regarding company stock.

When making your rollover, you might just assume that you'd sell all the investments in your account and invest the proceeds in new investments offered by your next provider. But I recommend you think twice about this when you have company stock in your account.

First, you may not be able to control the exact date when your stock is sold. As a result, you might not get the best sale price. While selling the stock when it's still in your 401(k) plan can help you avoid paying broker commissions, it's best to have control over the timing of the stock sale and elect to move the company stock "in-kind" (as stock shares) into the new rollover account.

In the long run, however, you can often do even better if you transfer your company stock in-kind to a taxable account instead of rolling it over. Unlike other investments in your company's retirement plan, shares of company stock may be eligible for special tax treatment after you leave your employer. This is due to something called net unrealized appreciation (NUA), and can work in your favor if you're holding company stock that's greatly appreciated.

In short, NUA is a strategy that allows you to take advantage of the lower long-term capital gains tax rates versus your ordinary income tax rate when cashing in stock upon leaving an employer. Using this strategy, you can take a lump-sum distribution of company stock (transferring it to a taxable account in-kind) and pay the ordinary income taxes on the stock's cost basis, plus the 10 percent penalty if you're under 55.

You can find out more about NUA here.

5. Going it alone.

Finally, if you're unsure of what the best move is for your individual situation, seek the advice of a professional tax adviser, money coach, or financial advisor.

After all, this is your retirement nest egg we're talking about. It took you years -- if not a lifetime -- to accumulate it, so don't take chances with it now.

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73 Comments

Showing comments 6-35 of 73<< PreviousNext >>
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  • JanP - Sunday, October 14, 2007, 11:43AM ET  Report Abuse

    • Overall: 4/5

    Can you rollover a 401K to an IRA while you are still employed with the same employer?

  • Jerome - Friday, October 12, 2007, 10:35PM ET  Report Abuse

    • Overall: 1/5

    Lots of hypotheticals.

  • Yahoo! Finance User - Friday, October 12, 2007, 6:16PM ET  Report Abuse

    • Overall: 4/5

    It might be worth exploring what happens if you leave the money in the employer's 401K and then die before you are old enough to collect it.

  • Yahoo! Finance User - Friday, October 12, 2007, 10:28AM ET  Report Abuse

    • Overall: 5/5

    Roll it out of your company's 401K to an IRA. I have had three different 403B plans with the same employer. Don't know where they got these turkeys. I made more on my IRA in one year than in 5 years in the 403B plans.

  • marge - Friday, October 12, 2007, 10:16AM ET  Report Abuse

    • Overall: 4/5

    I left my employer of 27 years while angry: I quit! I wasn't in a state of mind to think of my 401(k), and was surprised to receive a check in the mail a few months later for $52,000 plus. I wish I had a resource such as this article then, as I didn't do anything with the money except to spend it, albeit slowly, on things I saw as needing: repairs to the house, etc. Then I got my tax bill several months afterward. What a shock! I am now wiser but poorer due to penalties and interest imposed by the IRS. Very good article.

  • Yahoo! Finance User - Thursday, October 11, 2007, 5:02PM ET  Report Abuse

    • Overall: 4/5

    To the person who commented about rolling over to a new employer, I think the author is referring to a rollover to an IRA. He touts the IRA as a more versatile option than what most companies 401ks offer.

  • Karin - Thursday, October 11, 2007, 4:39PM ET  Report Abuse

    • Overall: 5/5

    Mr. Bach, keep up the good work. There is no such thing as information overload in this area.

  • DannyO - Thursday, October 11, 2007, 3:01PM ET  Report Abuse

    • Overall: 5/5

    This is excellent advice! A great read. I'm 60 and I had to pay the tax penalty on my money. The company I had my money with, sent it to me in my name. I now have to fight the IRS at tax time to try and get back some of that tax money that should be mine now.

  • Ken - Thursday, October 11, 2007, 12:52PM ET  Report Abuse

    • Overall: 2/5

    Last time I decided to roll my 401K over to my new job, what a mistake. For two months nobody knew where my money was. "Its in the mail" and "we are processing your money" gets frustrating. Do NOT roll your money over. It just makes money for somebody else while it is being "processed" for two months.

  • B - Thursday, October 11, 2007, 12:03PM ET  Report Abuse

    • Overall: 4/5

    this is all very important to me. im 56 and after 27 years im taking early retirement. there is so much to learn FAST so i dont mess anything up. id be curious to know what you would recommend: i have no debt; modest lifestyle; low pension; will be receiving about a 50k vacation/sick time payout and do not want to get hit with taxes. for 2007 ive had max amount and catch up for my 405b. is there any way i can avoid high income tax? thanks.

  • First L - Thursday, October 11, 2007, 11:56AM ET  Report Abuse

    • Overall: 5/5

    I really enjoyed this info. I just got laid off and I did roll mine over to another company, and from what I read I did things correctly. Wow for once, my mom would be proud. LOL

  • Yahoo! Finance User - Thursday, October 11, 2007, 11:41AM ET  Report Abuse

    • Overall: 2/5

    I would like verification that the law has not changed regarding withdrawal and reinvestment. I have been told recently that if you take a check at all in the reinvestment process you will pay capital gains, that the law now required rollover direct from bank or fund to the new fund/bank.

  • Yahoo! Finance User - Thursday, October 11, 2007, 10:10AM ET  Report Abuse

    • Overall: 4/5

    And what do you advise for a spouse receiving the funds of a 401k via a QDRO (Qualified Dependant Relations Order) in a divorce settlement? What kind of taxes and or penalty (if any) are involved?

  • Mary - Thursday, October 11, 2007, 9:37AM ET  Report Abuse

    • Overall: 5/5

    I found this information to be extremely helpful. I have been retired over l2 years, but just recently rolled over a tax sheltered annuity into an IRA account.

  • Yahoo! Finance User - Thursday, October 11, 2007, 8:48AM ET  Report Abuse

    • Overall: 5/5

    Find a good, honest professional (I prefer bankers) and keep in touch but don't anguish. Everything has its ups and downs.

  • __A_YAHOO_USER__ - Thursday, October 11, 2007, 7:34AM ET  Report Abuse

    • Overall: 5/5

    This is great info, especially for someone who plans on leaving their job soon, such as I.

  • CDG - Thursday, October 11, 2007, 7:03AM ET  Report Abuse

    • Overall: 1/5

    I thought this may contain some information above what a third grader already knows

  • Yahoo! Finance User - Thursday, October 11, 2007, 5:57AM ET  Report Abuse

    • Overall: 5/5

    Your help is greatly appreciated.

  • PETER - Thursday, October 11, 2007, 5:32AM ET  Report Abuse

    • Overall: 4/5

    tips for the late baby boomers (or any age these days), very well presented, it's all about making your money work harder than you do

  • Sean - Thursday, October 11, 2007, 5:18AM ET  Report Abuse

    • Overall: 1/5

    I just do not see how #2 is a "biggest mistake". I have multiple 401(k)s from old companies, and like one of the posters said, if you are on this blog, you have access to the internet, so you can monitor you accounts. The financial industry pushes the myth that you have to move becuase that is how they make their money.

  • James - Wednesday, October 10, 2007, 7:18PM ET  Report Abuse

    • Overall: 4/5

    "YOU CANNOT DO THIS IF YOU HAVE ALREADY ROLLED OVER INTO AN IRA. This is an extremely important IRS ruling that the majority of even financial professionals do not know about." I think christophergouin misunderstands the rule on the IRS web page. The exception mentioned applies to everything except an IRA account. Trying to take a distribution from a 401k or any retirement account other than an IRA will result in a penalty if taken between age 55 and 59 1/2. The IRA is the only account that gets an exception to this rule per the IRS website. http://www.irs.gov/taxtopics/tc558.html "The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA: " If I understand this correctly this is an exception to the previously mentioned expections. I'm going to contact the IRS for confirmation on this. James Williams Certified Estate Planning Professional Pleasanton, CA

  • Yahoo! Finance User - Wednesday, October 10, 2007, 6:25PM ET  Report Abuse

    • Overall: 5/5

    Very useful information.

  • Scott E - Wednesday, October 10, 2007, 5:48PM ET  Report Abuse

    • Overall: 3/5

    Annuities are rarely good? Excuse me, but I have a Variable Annuity with daily locks that made a KILLING during the volatility in August. As to extra fees ... Do you have car insurance, house insurance, health insurance, life insurance, etc., etc? So you have insurance for all these things, but insurance for my investments ... thats ludicrous. Who would want to secure their investment from losses in the market? Oh ... I guess I would.

  • Yahoo! Finance User - Wednesday, October 10, 2007, 3:09PM ET  Report Abuse

    • Overall: 4/5

    Annuities are rarely a good choice...very high expenses and not flexible for transfers. IRA's can't be borrowed against.

  • wxwxwxw - Wednesday, October 10, 2007, 2:41PM ET  Report Abuse

    • Overall: 4/5

    People... please! For those advocating leaving it in your existing 401K - you can almost always invest in the same funds in you roll it over into an IRA - For those of you whining that there's not more advanced information - please read again. See #5 - work with a good INDEPENDENT financial advisor who can advise you on YOUR specific circumstances and address the more advanced topics.

  • Yahoo! Finance User - Wednesday, October 10, 2007, 2:19PM ET  Report Abuse

    • Overall: 3/5

    This is basic stuff, except for the company stock info. That was good. Like to see more advanced information

  • Quintanilla - Wednesday, October 10, 2007, 11:58AM ET  Report Abuse

    • Overall: 4/5

    How about giving choices to where to roll over your 401K. Are annuities a good choice is you are over 60?

  • Yahoo! Finance User - Wednesday, October 10, 2007, 11:47AM ET  Report Abuse

    • Overall: 3/5

    It was OK. I think some of the info is very basic. I feel I know very little about finance but I knew about 75% of what is written; however, very good article for the ones that know nothing. I want to read an article about the major difference between 401K and IRA. For example, my brother-in-law just cashed out of his old 401K and I told him big mistake, mainly because of what is written in this article. I said he should've taken out a loan out of his 401K, it is like paying yourself back with interest. I also said only 401K's allow you to take loans, IRA will not allow to do that. Am I right??? I'm not sure. Also, an article about Stock Options would be nice; my company gave me Options about 1.5 years ago as a incentive to stay longer, and again, I feel I know very little about Stock Options.

  • Yahoo! Finance User - Wednesday, October 10, 2007, 10:46AM ET  Report Abuse

    • Overall: 3/5

    Good info but nothing the average person reading a Finance website wouldn't probably already know. One mistake I made was leaving my 401k in my company's plan after I left the company. The funds were horrible and the returns were even worse. About a year ago, I finally rolled my plan over to T. Rowe Price and had a 20% return in the past year. It would have taken the company plan, with all it's poor funds, years to attain that return.

  • Christopher - Wednesday, October 10, 2007, 10:40AM ET  Report Abuse

    • Overall: 3/5

    URGENT NOTE TO READERS: Mr. Bach is accurate with his comments, but EARLY RETIREES BEWARE. There are some important benefits with NOT rolling over. Most importantly, if you retire after 55 but before 59 1/2 years of age, you can withdraw money from a 401K (and other retirement plans) PENALTY FREE. YOU CANNOT DO THIS IF YOU HAVE ALREADY ROLLED OVER INTO AN IRA. This is an extremely important IRS ruling that the majority of even financial professionals do not know about (or ignore divulging for self-serving reasons). For further information, go to www.irs.gov and go to (or search for) "Topic 558 - Tax on Early Distributions from Retirement Plans", which includes this verbage, "There are certain exceptions to this (10% early withdrawal) penalty. The following five exceptions apply to distributions from any qualified retirement plan" (I've shown only the key one): "Distributions made to you after you separated from service with your employer, if the separation occurred in or after the year you reached age 55" Chris Gouin, Certified Financial Planner Fort Mill, South Carolina

Showing comments 6-35 of 73<< PreviousNext >>

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