How to Protect Your 401(k) if You Leave Your Job

You thought the hardest part about saving for retirement was figuring out the best place to invest your money? Here's another head-scratcher: what to do with your 401(k) when you leave your job.

Generally, you can leave the money with your ex-employer, move it to your new employer's plan (if that company allows it), roll it to an individual retirement account or cash out. Each choice comes with potentially negative consequences for your savings.

Luckily, you usually have some time to decide. If you have $5,000 or more in the plan, your former employer must let you leave it there until you turn 65, said David Wray, president of the Profit Sharing/401(k) Council of America, a group that represents employers who offer retirement plans.

If you have between $1,000 and $5,000, and don't choose one of the above options, the company is allowed to roll the money into an IRA it opens for you. If you have less than $1,000, the employer can cash it out and mail you a check.

Plenty of people leave their money in a former employer's plan. Wray estimates, based on U.S. Labor Department data, that about 15 million accounts owned by ex-employees are stashed in employer plans (including multiple accounts owned by one person). Brightscope Inc., a 401(k) rating company, found in its database 10 large employers where ex-employee accounts represent more than 60% of each firm's 401(k) accounts.

Leaving it in your employer plan may not be the worst idea. But whatever you do, try to avoid cashing out. Say you've got $50,000 in your 401(k) and pay a federal income tax rate of 25% and state rate of 7%. Those taxes plus the 10% penalty for early withdrawal will leave you with just $29,000. (The 10% penalty doesn't apply if you leave your job and cash out your 401(k) plan at age 55 or older, according to Fidelity Investments.)

You can avoid the tax hit by rolling it into another tax-qualified plan, such as an IRA or your new employer's 401(k). Before you make a decision, consider your personality, said Scott Holsopple, president of Smart401k, which offers portfolio-management services.

A do-it-yourself investor may prefer an IRA, with access to more investment options, he said. But if you're unlikely to do the work of finding low-cost investments, you may benefit from keeping the money in a 401(k), depending on the size of the plan. Large employers' plans often include low-cost investment options because they can negotiate lower expenses — you're getting institutional rather than retail prices.

New regulations should bring better fee disclosures for 401(k) investors next year. For now, to compare costs of an IRA and 401(k), focus on investment expenses. That's the best proxy for total 401(k) costs, said Robyn Credico, defined-contribution practice leader at consulting firm Towers Watson. "Ninety-five percent of your expense is your investment expenses, so you can come pretty close just by looking at that," she said.

Compare services, too. "For a lot of 401(k) plans that I serve, I do one-on-one consulting and education with the participants," said Michael Chisnell Jr., director of retirement services at Sequoia Financial Group, a money-management and 401(k) advisory firm in Akron, Ohio.

If your former employer doesn't offer much help, it might make sense to move your money to an IRA.

Another advantage of rolling the money into an IRA is that combining your funds in a single account makes managing a diversified portfolio easier, said Ryan Alfred, president of 401(k) rating company Brightscope.

"The perceived advantage [of employer plans] is you're getting institutional pricing on a couple of the funds," Alfred said. But it's easy to find cheap investments in IRAs, and few investors do "a great job of managing all of their [disparate] accounts as one."

If you choose to roll your money into an IRA or new 401(k), ask for a trustee-to-trustee transfer, where the custodian of your old account pays the money directly to the new plan's custodian.

If a check does come to you, you need to get the money into the new plan within 60 days or it may be considered an early withdrawal — and taxes and penalties may apply. The hitch, even if you deposit that check by the deadline: Since the money went to you first, your former employer must withhold 20% of the account balance for tax purposes. That means you must come up with that 20% to put in the new account yourself or that amount is considered a distribution. (You'll get credit for the 20% withheld when you file your income taxes.)

Creating retirement income

If you're near retirement, your ability to start distributions becomes a key metric in your decision. If you don't need the money just yet, you might leave it in your old plan until you do, though some plans may force you out at age 65.

Along with access to more investment options, IRAs generally give you more freedom than a 401(k) to manage your money when you're ready to create an income stream from your account, including buying an annuity or setting up regular withdrawals.

Still, some 401(k)s help retirees create retirement income. A few offer systematic payments in an amount of your choosing. Plans with a managed-account option may extend those services to retirees in the form of help managing withdrawals, said Pamela Hess, director of retirement research at consulting firm Aon Hewitt. Plus, some plans offer annuity options. Ask your employer whether your plan offers any retirement-income tools.

But if you plan to work past age 70-1/2, keeping your money in the 401(k) where you work could let you delay the distributions required of 401(k) and IRA owners at that age, according to Fidelity. A person who is actively employed (and not the owner of the company) may be able to delay required minimum distributions until retirement.

Also, with a new employer's 401(k) plan, you have access to loans from that account, if the plan offers the option.