For better or worse the 401(k) seems to be the main savings vehicle for Americans, so it always shocks me how little most people actually know about it. Financial Advisor Magazine (along with every other main stream media outlet) jumped on a recent report by Fidelity (oddly enough none of these main stream outlets seem to be linking to the report), which highlights a significant problem.
- 35 percent of all participants in plans it administers cashed out their 401(k) balances when leaving their jobs last year…
- Four out of 10 workers (41 percent) age 20 to 39 cashed out, and 51 percent of workers who left jobs grossing under $30,000 cashed out
I have to believe that most of these distributions had less to do with need of the cash versus not understanding their options. This pure gut sentiment has to do with the thought that if cash was that tight they wouldn’t be contributing/participating in these plans. This is not to say an “extra” $X coming out of a retirement plan they didn’t remember wouldn’t help any family but at what cost?
HelloWallet, a firm that provides software-based financial guidance tools for employers and employees, analyzed Federal Reserve data and found that $60 billion was cashed out from workplace plans in 2010, up from $36 billion in 2004.
In recent years I have moved away from posts about simple information that can be found anywhere but with statistics like the one above maybe someone seeing this post may avoid a terrible mistake.
How Does one Transfer their Employer Sponsored 401(k) to an IRA?
Known in the financial world as a rollover the transaction is relatively easy although obviously not utilized enough. For most tax issues I like to go to the source (IRS) which has an easy to understand guide titled, Tax Topic 413,
A rollover occurs when you withdraw cash or other assets from one eligible retirement plan and contribute all or part of it, within 60 days, to another eligible retirement plan. This rollover transaction is not taxable but it is reportable on your federal tax return. You can roll over most distributions from an eligible retirement plan except for:
- The nontaxable part of a distribution, such as your after-tax contributions to a retirement plan (in certain situations after-tax contributions can be rolled over),
- A distribution that is one of a series of payments made for your life (or life expectancy), or the joint lives (or joint life expectancies) of you and your beneficiary, or made for a specified period of 10 years or more,
- A required minimum distribution,
- A hardship distribution,
- Dividends paid on employer securities, or
- The cost of life insurance coverage.
Further exclusions exist for certain loans and corrective distributions.
The taxable amount of a distribution that is not rolled over must be included in income in the year of the distribution. If an eligible rollover distribution is paid to you, you have 60 days from the date you receive it to roll it over to another eligible retirement plan. Any taxable eligible rollover distribution paid from an employer-sponsored retirement plan to you is subject to a mandatory income tax withholding of 20%, even if you intend to roll it over later. If you do roll it over, and want to defer tax on the entire taxable portion, you will have to add funds from other sources equal to the amount withheld. You can choose to have the payer transfer a distribution directly to another eligible retirement plan or to an IRA. Under this direct rollover option, the 20% mandatory withholding does not apply.
In general, if you are under age 59½ at the time of the distribution, any taxable portion not rolled over may be subject to a 10% additional tax on early distributions unless an exception applies.
Wait a minute lets read that last part which I emphasized! Re-read it? Yup, if you are under 59 and 1/2 years old (no freaking clue where they got the half) then to access your own money you are TAXED and then hit with a 10% additional penalty. Lets take a look at an example:
- You are 35 and work for a company for 5 years and amass $40,000 in your 401(k).
- You get fired or decide to leave and you get a call from HR and they say you can roll it over somewhere OR I can have the plan admin send you a check.
- You think to yourself I’ll just take a check I needed my bathroom redone.
- Your $40,000 is then taxable income so if you are in the 20% bracket that is $8,000 off the top.
- You are then penalized another $4,000 ($40K * 10% Penalty).
- Ignoring opportunity and compounding your $40,000 is really worth $28,000.
So nearly 800 words later we get back to the title of this blog post – DO NOT LIQUIDATE YOUR 401(k)! If you are leaving your job find out about a rollover.