When you say goodbye to an old employer don’t forget about the retirement account that you’ve been funding. I’ll tell you who owns the money in your workplace retirement plan—like a 401(k), 403(b), or 457—and give you 5 options for dealing with the account after you leave the job. The Thrift Savings Plan is very similar to these employer sponsored retirement plans, but there are a few other considerations to keep in mind when you leave the military or civil service. We have covered options for your TSP when you leave the service in a previous article. This article covers 401k plans and other employer sponsored plans.
Who Owns Your Old 401(k)?
Once you’re no longer employed, you can’t make new contributions to your old retirement account. However, you still own it and can control the vested portion of your account.
You’re always 100% vested in contributions made from your paycheck plus their earnings, according to the Employee Retirement Income Security Act (ERISA). That means, no matter what, your employer can’t take those funds away from you.
However, any portion of your retirement account that is not vested will be reclaimed by your employer if you leave. Contributions that your employer makes, like matching or profit-sharing funds, are typically subject to a vesting schedule. To know if you’re fully vested, read your plan’s policy for the details.
How Does Vesting Work?
The 2 main types of vesting that are used in workplace retirement plans are graduated vesting and cliff vesting:
- Graduated vesting is when you take ownership of an employee benefit on a gradual schedule, such as 20% per year after completing one full year of work. An employee with this schedule would be 20% vested after 2 years, 40% after 3 years, 60% after 4 years, 80% after 5 years, and 100% after completing 6 years of service.
- Cliff vesting is when you take ownership of an employee benefit all at once, such as 100% after 3 years of service.
Leaving work before you’re fully vested means you may lose a portion or all of any employer-provided funds that are not vested on the date of your termination.
So, once you’re gone, what should you do with your vested retirement account balance? Here are 5 options:
Option #1: Cash Out
Your first option for an old retirement account is to cash it out. This is the worst option because you’ll have to pay state and federal tax on the withdrawal, plus a 10% early withdrawal penalty if you’re younger than age 59½.
For example, if you have approximately $10,000 in your 401(k) and pay an average tax rate of 25%, you’ll pay a total of 35% (25% plus the 10% penalty) in tax, leaving you with just $6,500 ($10,000 minus $3,500). That could wipe out every penny of earnings in the account or leave you worse off than if you had never invested the money in the first place.
Many people cash out their workplace retirement account because they don’t realize that there are other options. I’d rather you choose any of the other 4 options that I’m going to cover than to default to a money-losing cash out.
Option #2: Do Nothing
Your second option for an old retirement account is to do nothing and leave it with your previous employer. Generally, this isn’t a good option because you don’t know what will happen to the company, the benefits administrator, or the retirement plan down the road.
However, if you like the investment options in your old account, you can keep it. Just make sure you have a contact name and phone number for the brokerage of record on the account or the plan custodian, so you never lose touch with the people who administer the retirement plan.
If you left a Fortune 500 company, contacting a knowledgeable person in the benefits department won’t be a problem. But if you worked for a small business with one person in charge of human resources, for instance, it could be a real hassle to get accurate or timely information about your old retirement plan years later.
It’s easier to keep a retirement account with your old employer when you have online access to it. If you can check your balance, reallocate your investments, and change your contact information on your own, then you may be satisfied leaving the account with your former employer.
Option #3: Rollover to a New Workplace Retirement Plan
The third option for an old retirement account is to roll it over into a retirement plan at your new job. However, I only recommend this option if your new plan is fantastic and offers a wide range of low-fee investment options.
You should sign up for your new workplace plan because you can contribute up to $16,500 (or up to $22,000 if you’re 50 or older) for 2011. Plus, you can build your nest egg faster from matching funds that might be offered by your employer.
As you get familiar with the new plan, you can decide whether you want to rollover your old retirement account funds into it or not. If it’s not a great plan or you simply want more control over how the money is invested, go with one of the last 2 options I’m going to cover.
Option #4: Rollover to a Traditional IRA
The fourth option for an old retirement account is to roll it over into a traditional Individual Retirement Arrangement (IRA). This will give you the most investment options and freedom from the restrictions of a workplace retirement plan.
You can open up a traditional IRA at any number of brick and mortar brokerages, banking institutions, or online brokerages—like etrade.com, vanguard.com, or schwab.com. After the new IRA is open, request a rollover distribution from your former plan, and pick your new investments. You can rollover the entire amount, but going forward your new contributions are limited to a maximum of $5,000 (or $6,000 if you’re 50 or older) for 2011.
Contributions to a traditional IRA are made on a pre-tax basis, which means you typically don’t pay tax on them or on your earnings until you make withdrawals. However, depending on your income, some IRA contributions may not be tax-deductible if you also participate in a workplace retirement plan. Read Should You Contribute to Both a 401(k) and an IRA? for more details.
Option #5: Rollover to a Roth IRA
The fifth option for an old retirement account is to roll it over into a Roth IRA. Unlike a traditional IRA, contributions to a Roth are not tax-deductible and must be made with after-tax income.
So doing a rollover from a traditional 401(k) into a Roth IRA means that you have to pay tax on any contributions that weren’t already taxed. However, once you pay it, you’re never taxed on contributions or earnings in the account ever again. All your qualified withdrawals from a Roth IRA are completely tax free.
It’s just as easy to open up a Roth IRA as it is for a traditional IRA. The process for doing a rollover is the same—except for the tax part. You can contribute up to $5,000 (or up to $6,000 if you’re 50 or older) for 2011. To be eligible to contribute to a Roth IRA, there are annual income restrictions.
To learn more about Roth IRAs and which kind of IRA is best for your situation, grab a copy (or an e-book download) of my award-winning book Money Girl’s Smart Moves to Grow Rich.