Early Withdrawal

I know it’s tempting. You’re looking at that last 401k statement you got from your old employer and you’re thinking about just cashing out and getting several thousand dollars to spend. You may even have some unexpected bills that just popped up and taking the money would be a great way to pay for them. But I can say, without hesitation, that this is absolutely one of the worst financial decisions you can make.

Cashing out of your 401k, or taking an early withdrawal, means you’ll pay somewhere around 30 to 40% of your balance in taxes. That means for every $1,000 you have saved, you’ll pay $300 to $400 in taxes. That is not a good deal. And anyway, you were saving that money for retirement, right? Don’t undo the goal that you’ve been working toward all these years by pulling your cash out.

Getting The Paperwork Right

Speaking of taking an early withdrawal, it’s important to make sure that you fill out the rollover paperwork correctly so that you don’t accidentally withdraw your money. Any option that sends you the money is considered an early withdrawal. Even if you’re planning on taking the money straight to your bank and depositing it into an IRA, your old employer is required by law to withhold the appropriate taxes and penalties.

When you’re checking through the options, you want to select “direct rollover” or something similar. In a normal 401k rollover, the funds will be handled by the two financial companies (your old one and your new one) and you’ll never see or have to handle the money directly.

Don’t Take Too Long To Act

With all of the various options out there, it’s often easier to just do nothing about your old 401k instead of actually figuring out what to do about it. The problem with this is that it’s so easy to forget all about your 401k, and the next thing you know it’s 4 or 5 years later and you still haven’t done anything with it. The real problem with this is that you’re almost certainly not monitoring the funds in that account, and you won’t know if things start to change for the worse.

If you’re starting a new job and have a 401k that you need to rollover, give yourself 6 months to do something about it. 6 months is plenty of time to get comfortable in your new job, investigate all of the investment options out there, and get the paperwork done. If you haven’t taken any action at the end of 6 months, just roll the old 401k into your new 401k and be done with it.

For discussion of some other things to avoid in a rollover, check out this post on the drawbacks of doing a 401k rollover.

Leave The Money Where It Is

The quickest and easiest solution is to simply do nothing with the money. In most cases, you are allowed to leave the funds in your old 401k account indefinitely. The money will simply remain in the specific investments that you’ve chosen, and you can even choose new investments as your old employer makes them available.

Pros: Quick and easy. There’s nothing quite as simple as doing nothing.

Cons: Choosing to leave the money with your old employer is really a temporary solution at best. This is probably not the wisest choice for the long term. Leaving the money in your old 401k means that you’re limited in your investment options, and you have limited control over the money. Move the money into a new account at the institution of your choice, and you’ll have more control and more investment options available.

Roll The Money Into A New 401k

Another quick and easy solution for a 401k rollover is to move the money into the 401k offered by your new employer. You can roll the money right in and have it invested in the same account as your new 401k. This is a popular choice for many people because it keeps all of your 401k monies together in the same place.

Pros: Many people like this option because of the simplicity. Instead of having multiple investment accounts spread out among different brokers and investment firms, you can have all of your retirement savings in one account with easy access. This is a big plus for people who are looking for a “set it and forget it” retirement plan and who do not want to spend a lot of time choosing investments.

Cons: Having all of your money invested in the same 401k account does limit your investment options. You’ll only have access to the specific funds and investments made available by your employer. If you are the type of investor who likes to have access to lots of different investment options, or if you want to invest in a specific stock or mutual fund, this is probably not the best option for you. Another drawback to rolling the money into your new 401k is that if you leave this job at some point down the road, you’ll have to go through the whole process again.

Early Withdrawal

The last quick and easy solution for dealing with an old 401k is to withdraw all of the fund in the account. Your ex-employer will sell everything that you’re holding in the account, and send you a check. This is a poor financial decision, for the reasons that we’ll see below.

Pros: Quick, easy, and you get some cash.

Cons: Where to start. First, if you pull the money out of your 401k, you’re working to defeat your own goals. You started putting that money aside for a reason (your retirement!) and pulling the money out now will negate any savings you’ve managed to do. Second, you’re going to pay taxes out the wazoo. The money that you put into a 401k is not taxed – until you withdraw it. If you cash out of your old 401k, the standard federal and state income taxes will apply. This will be 25 to 30%. In addition, a 10% penalty is tacked on top of that, so you’re looking at paying 30 to 40% in taxes right off the top. This means if you have $1,000 in your 401k, you’ll only receive $600 to $700 in cash.

Best Quick and Easy Solution

If you’re looking to minimize the amount of time you have to spend doing a 401k rollover, the best long term solution is to roll your money into your new 401k. The early withdrawal is clearly a bad choice, and leaving the money in your old 401k is really only good for a short amount of time. If you don’t have a new 401k available or if you want more investment options, then you’ll want to look into one of the more flexible 401k rollover options.

401k Accounts

A 401k is in many ways similar to any other type of retirement account. It allows you to save money for retirement with specific tax advantages; in this case, the money that you put into your 401k and the earnings that you generate from your investments are not taxed until you begin to withdraw funds. The way that 401k accounts differ from other retirement accounts is that your 401k is tied to your employer. Even though you own the account and the money inside of it, your employer handles many of the details of the account. We’ll discuss this more later, but for now you just need to know that your 401k is linked to your employer.

If you leave your current job and have money invested in the 401k, you have to decide what you want to do with that money. Since you’re no longer an employee at that company, you cannot continue to contribute to that account. You have several options as to what you want to do with the money, and deciding between the different options is the crux of the 401k rollover issue.

401k Rollover Options

When you have money invested in a 401k at an old job, you essentially have four options as to what to do with your money: withdraw the money, leave it where it is, roll the money into a new 401k, and roll the money into an IRA. Let’s look at each of these options.

Withdrawing the money you have invested in the 401k – i.e., having your old employer cash the account out and send you a check – is the worst choice you can make financially, for several reasons. First off, the money that you have invested was put there for a reason – your retirement. Pulling the money out now defeats the purpose of putting it away for later. Secondly, you’re going to pay a large amount in taxes. Remember how the money was not taxed when you put it in? Well, if you pull it out now, you’re going to pay the regular federal and state taxes on the money, plus an additional 10% penalty. This could easily reach a 30% to 40% tax rate on your money, which means for every $1,000 you have in the 401k, you’re only going to receive $600 to $700. This is a bad move. Avoid it.

Read the second part of this article for more 401k Rollover options.