When you change employers, you typically have several options for your retirement savings: Leave the money where it is, roll it into an individual retirement account, move it into a new employer’s plan or cash it out. Each choice affects your taxes, access to funds and long-term growth in different ways.
Most people simply roll the funds from their 401(k), 403(b), 457(b) or other profit-sharing plans into an IRA. Sometimes that is indeed the best option, but many do not realize it is not the only one. You can also move the money into a new employer’s plan, keep it with your old employer or cash out the funds. To decide how to proceed, consider the tax and financial consequences of your decision as well as what may or may not be allowable by law.
If you wish to move the money into your new employer’s plan, ensure that the proceeds from the old plan are sent directly to the new one. If the rollover check is sent to you, the old plan is required to withhold 20% of the balance for taxes. Furthermore, you have only 60 days to redeposit the full amount, including the withheld portion, which you will need to cover yourself, to avoid taxes and potential penalties.
Make sure you are fully vested in the old employer’s plan. If your old employer contributed matching funds, those employer dollars may not belong to you right away. Many plans use a vesting schedule — such as 20% ownership after year one, 40% after year two and full ownership after year five. If you leave before being fully vested, you could receive a smaller payout than expected.
Another option is to withdraw the funds as cash, which is usually the most expensive choice. Withdrawals are taxed as ordinary income, and if you are under age 59 1/2, taking money out of your retirement account may trigger a 10% additional tax or early distribution penalty, unless you qualify for an exception. The rules are complicated, and different types of retirement plans have different exceptions; without knowing the rules that apply to your plan, you may inadvertently trigger a penalty.
Here are two additional considerations:
Company stock. If your employer-sponsored retirement account includes company stock, that stock may qualify for a special tax rule called net unrealized appreciation. NUA is the difference between the stock’s cost basis and its current market value. When you sell shares that qualify for NUA treatment, that difference is taxed at capital gains rates rather than as ordinary income. Because ordinary income tax rates are typically much higher than capital gains rates, this can significantly reduce the taxes you owe — especially if you hold a large amount of company stock.
To qualify for this special tax treatment, you must experience a triggering event, such as separation from employment, disability, or reaching age 59 1/2. Then, you must take a lump-sum distribution of the account.
Loans. If you took a loan from your retirement account, different repayment rules may apply when you leave your job. In many plans, the loan must be repaid immediately or within a short time after separation. If you cannot repay it, the outstanding balance is treated as a taxable distribution and included in your ordinary income. If you are age 59 1/2 or younger at that time, that amount may also be subject to the 10% early withdrawal penalty.
The rules governing these decisions are complicated and the financial consequences of mistakes can be significant. Consult a tax professional to ensure you fully understand the tax implications of your choice.
