By Cyril S. White, Certified Financial Planner™
As people transition from one
employer to another, many are still uncertain about what to do with their
401(k) plan when they leave their employer. Here are 4 of the biggest mistakes
you should avoid when considering what to do with your 401(k).
A plan participant
leaving an employer typically has four options (and may engage in a combination
of these options as well), each choice offering advantages and disadvantages.
1. Leave the money in
his/her former employer’s plan, if permitted;
2. Roll over the
assets to his/her new employer’s plan, if one is available and rollovers are
permitted;
3. Roll over to an
Individual Retirement Account (IRA); or
4. Cash out the
account value.
Each of these
options can have a significant impact on your financial goals if not planned
and implemented correctly.
We have found that
there are four major mistakes people make with regard to their employer
sponsored retirement plan after they have separated from employment from
them.
This a bad idea altogether and truly defeats the purpose of having dollars earmarked for retirement. If you are under 59 1/2 years of age, you will pay a 10% early distribution penalty (source IRS.gov). In addition, the distribution will be treated as ordinary income in the tax year that you take the distribution. This could potentially cost you up to 30 or 40% of your balance based upon your personal income tax brackets. Lastly, the government withholds 20% of your check when you have your distribution check made payable to yourself which will make your net check from the 401(k) even lower. While you may be eligible to receive some of this back when you file your taxes, consider what the after tax check amount will be no matter how small or large your balance is within the 401(k) plan.
Many people are unaware of how a
direct transfer of your 401(k) plan to a rollover IRA actually works. Since it can be a very intimidating process,
many people just choose the path of least resistance and leave the money at
their old place of employment. Most 401(k)s have limited investment choices. With a rollover IRA account there can
be many more investment choices to select from. If the paperwork is completed
correctly, a 401(k) to rollover IRA transfer can be one of the easiest things
to get done in your personal financial plan to gain control of your retirement.
Mistake #3: NET UNREALIZED APPRECIATION
If you work for a company where you are buying company stock within your retirement
plan, when you leave your employer, there is a crucial tax management decision regarding
what you should
do with the company stock.
You have the opportunity to pay ordinary income tax on your cost basis of the company stock, and pay capital gains tax on the growth if the election is done successfully.
However, once you rollover your 401(k) to an IRA, this election will no longer be available. People who have worked for a long period of time for one employer where they have a sizable amount of
company stock do not often realize the implication of missing
out on Net Unrealized
Appreciation option. Please consult your tax advisor or go to
www.irs.gov to learn more about
this option.
Mistake #4: LEAVE IN “SET IT AND FORGET IT” STRATEGY
One of the most popular products used in 401(k) plans are the Target or
Lifecycle Retirement funds. These funds typically have names such as “Target
2035” in your 401(k) plan. The idea of these funds is that the fund company
will do the work and adjust the asset allocation (e.g., how much you have
invested in stocks, fixed income and cash) balances until you retire in in the year designated
by the fund name (i.e., 2035 in our example).
Theoretically, the fund is supposed to become less risky the closer you
get to your “target date” Not all
these funds are created
equal and nothing is guaranteed.
Therefore, you want to make sure that your 401(k) portfolio asset
allocation is in fact working as advertised and taking the amount of risk you
are comfortable with.
The 401(k) plan is typically the
most important component of most people’s retirement plans. Knowing how to avoid these four common
mistakes can mean the difference between having to work longer or retiring when
you want to.
Comments