Several million Americans will retire over the next few years. Many millions more could change jobs. And many millions more could lose their jobs in the next recession.
If your situation is changing and you have a 401(k) type retirement plan at work, an important decision awaits you: whether to transfer your retirement money to an Individual Retirement Account when you leave or change employment, keep the money where it is – transfer it to a new employer’s plan — or cash it in entirely?
It’s a dilemma that’s more topical amid the musical chairs unleashed by the Great Resignation. Some people will face this question several times during their career. Many factors come into play, including taxes. It’s a decision best pondered before the clock starts ticking.
Why you shouldn’t cash out
Cashing in on a retirement account can be tempting, especially if you have pressing financial obligations. But it’s often the worst choice from a tax and investment perspective, said Jerry Korabik, financial adviser at Savant Wealth Management, which has offices in Arizona, Illinois and five other states.
With a direct withdrawal of funds from the retirement account, federal income taxes will be owed and possibly state taxes as well. The distribution could push you into a higher tax bracket, especially if hundreds of thousands of dollars or more are involved.
If you are under 59.5, a 10% tax penalty would also be due (there are some exceptions, such as total disability). A withdrawal is also subject to withholding tax.
Also, you would deplete your account prematurely, possibly significantly. The impact could be particularly strong if you pull out when the stock market is down. Cashing out is an option of last resort best avoided if possible, Korabik said during a webinar.
The case for leaving it alone
If you can instead leave your retirement account intact, the next question is whether you should leave it with your current employer, if that option is available. The alternatives ? Move it into a rolling IRA or roll the money into a new employer’s 401(k), assuming you change jobs and have that option.
Unlike an outright withdrawal, leaving the money in your 401(k) plan would delay any tax grabs, avoid the 10% penalty (if applicable), and keep your investments growing tax-deferred. You could achieve the same results by transferring the account balance to a new employer pension plan or transferring the money to an IRA.
Assuming your current 401(k) plan offers a decent range of investment choices at reasonable costs, it might be best to keep the account where it is. One upside: “401(k) plans are pretty well protected from creditors if you have a lawsuit,” Korabik said. IRAs also offer some protections, but they are generally not as strong.
If you transfer the money to a new employer 401(k) plan, you can also keep these enhanced creditor protections.
Some disadvantages of the 401(k) account
But your current 401(k) plan — or a new one — may not offer good low-cost investment options, and the costs may not be so transparent. Additionally, depending on the plan’s policies, you might see limited or costly future withdrawal options, Korabik warned.
IRAs can usually meet ongoing monthly withdrawal requests — a nice feature if you’re retired — but many 401(k) plans can’t, said Dana Anspach, financial adviser at Scottsdale-based Sensible Money. , writing in a blog. And IRAs are generally more adept at responding to state tax withholding requests, she added.
Incidentally, if your account balance is less than $1,000, your former employer will likely cash out your account automatically, but above $5,000 the company likely won’t force you out of the plan, Scott Laue said. , another financial advisor at Savant. If you’re between those dollar numbers, you’ll likely need to transfer the balance to an IRA, he said.
Either way, if you want to keep the money with your old employer or transfer it to a new plan, you should review the features governing those programs.
The case of transferring to an IRA
If keeping the money in a 401(k) program is not acceptable or available, you should seriously consider transferring it to an IRA by pursuing a rollover.
“A rollover is a tax-efficient way to transfer money (retirement account) from one bucket to another without paying taxes,” Korabik said.
One of the main advantages of choosing an IRA is that you’ll likely have more investment options and therefore more control compared to a 401(k) plan, although too many choices can also be intimidating.
Another perk, if you can afford it, is the ability to do qualified charity distribution on the go. This allows people age 70 and older to donate money from an IRA directly to a qualified nonprofit.
With a QCD, you wouldn’t get a tax deduction on the donation, as you would otherwise, but you wouldn’t pay taxes on the amount donated either. This can lower your taxable income, possibly keep your Social Security out of the taxable category, and even circumvent surcharges that apply to higher-income Medicare beneficiaries. Also, once you reach age 72, you generally must take the required minimum distributions. A QCD can be used to satisfy them.
Overview of Hover Types
With a bearing, it is important to understand the two main types. The first type of rollover is a direct transfer of money from one account custodian or trustee to another, either electronically or by check. In any case, no funds are sent to you personally. Nothing is taxed at this stage.
With an indirect rollover, your employer sends you a check or makes an electronic payment, assuming you’ll soon reinvest the proceeds in an IRA.
You have 60 days to rollover by depositing the money into your new IRA. If you miss this deadline or don’t transfer the money at all, the proceeds withdrawn become taxable and, if you are under 59.5, this 10% penalty will likely apply.
Another caveat with indirect rollovers is that taxes (typically 20% of proceeds) are withheld. You can get that money back when you file your tax return next year, but you’ll still have to find the full amount of the rollover or face tax, and possibly a penalty, on the shortfall.
For example, Korabik said that if you rolled over $10,000 of which $2,000 was withheld, you would receive $8,000 with the need to find the remaining $2,000 using other funds. You generally want to avoid indirect rollovers, he said, although the cash could be useful for a short-term loan if you can manage the timing.
Other Bearing Considerations
As noted, perhaps the main benefits of moving money from a 401(k) account to an IRA are that you’ll likely have more investment options and greater control. You can also consolidate accounts.
If you change jobs often, you may end up with multiple 401(k) accounts with the inherent problems of managing them all. “You could have 401(k) plans everywhere,” Korabik said.
The average job tenure is only around four years, so that’s a concern – with the possibility that you could forget money. There are 24 million forgotten 401(k) accounts worth $1.35 trillion, Laue said.
And if you have 401(k) accounts in lots of places, you’d want to update them all every time you change your address, bank account or payee, Anspach said. “It becomes one more thing to track regarding your finances and record keeping.”
So it would be best to get into the habit of transferring 401(k) balances into the same IRA every time you leave a job – or every time a job leaves you.
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