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Starting a new job is very exciting, but the transition brings with it a lot of confusion regarding benefits, particularly retirement plans such as a 401k. If you have just recently made a job switch, or are in the process of doing that, know your rights and your options.

First, 401k accounts are portable- you will take the money with you through a process called a rollover. Essentially you take the distribution of your vested balance- the total amount you accrued from your own contributions (pre-tax, after-tax, and Roth) along with the earnings. You are also entitled to your employer contributions and earnings if you have satisfied the vesting schedule.

Every 401k plan is different. Some offer immediate 100% vesting, others have graduated or “cliff” vesting until you are fully vested (usually between 3-6 years). If you are nearing satisfaction of the plan’s vesting schedule, try not leave prior to that. You never want to ever forfeit employer contributions if at all possible.

One of the big pitfalls when you know that a lump sum distribution is available is that there is temptation to spend the money rather than roll it over. This is often true of those who have been unemployed for a period of time and are behind in bills and obligations. Getting a big chunk of money at one time might look like a good way to pay off debt, but the downside is that you will be taxed at ordinary income tax rates on the entire value of the account (except for any after-tax or Roth 401k contributions). This can be very costly both in terms of a tax bill, but also by losing out on opportunities for compounding. You can’t ever recoup the years you worked and invested.

Also, if you are under age 55, an additional 10% penalty may apply for early withdrawal (due to the 5-year holding period requirement, there won’t be any tax-free qualified distributions from Roth 401k accounts until 2011 at the earliest). There are also special rules that apply to lump-sum distributions depending on your age and if the distribution includes employer stock.

The optimal strategy is to roll over the account into an IRA, which gives you the greatest amount of control and the greatest number of investment options. (If the balance exceeds $5000, you can leave it in the employer’s plan until you reach retirement age, but it is not recommended).

By law, the employer must allow you to make a direct rollover to an IRA- the entire amount money goes right from the 401k to your personal IRA. This way you never touch the money and the employer doesn’t hold on to any of it. If you take the 60-day rollover option, the employer withholds 20% of the taxable portion of the money, and you have to come up with that amount for your IRA deposit, until you file your income tax return.

The rules are complex, so be sure to discuss your options and rights with both your former and new employers, as well as your tax preparer and financial planner. You want your money working as hard for you as you worked to earn it.

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Tags: 401 contributions, 401k, 401k rollover, lee rosenberg, lee rosenberg cfp

About the Author: Lee Rosenberg is the Co-founder of ARS Financial Services, Inc. As a Certified Financial Planner with more than 34 years of solid financial expertise. Lee is a registered representative of Cadaret, Grant & Co., Inc. He was also named one of the top 25 Independent Financial Advisers in the US by Rep magazine.

This entry was posted on Wednesday, August 5th, 2009 at 9:55 am and is filed under 401k. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.