Money Talk: What to do with your retirement plan when changing jobs

These days, its extremely rare for individuals to start and end their career with the same employer. According to the US Bureau of Labor Statistics, the average worker born late in the Baby Boom (1957-1964) held more than twelve jobs during their career. Their job changes were understandably more frequent in their younger years, averaging 5.6 jobs from ages 18 to 24 and these employers were unlikely to offer much in the way of retirement benefits. But even individuals in their peak earning years (after age 45) experienced multiple job changes, switching employers 2.3 times on average. While building nest-eggs for retirement, each of these job changes were opportunities to make errors in handing employer-provided benefits, potentially triggering additional taxes and lost investment returns.

When leaving a job with retirement benefits, either in the form of a defined contribution plan like a 401(k) or the less common pension plan, departing employees have several options for dealing with these account balances. Like anything else, the ideal option depends on the particular situation.

The first option is simplest. Balances in old retirement accounts can simply be left where they are. Unless the balance is small, most 401(k) plans will allow assets to stay in the plan. Plan rules, however, might automatically call for 401(k) accounts of departing workers to be rolled over to an IRA plan to reduce the administrative burden of tracking plan participants with small balances. Departing workers with $1,000 or less in their employer retirement account should be prepared to receive a check for their account balance. When small balances are cashed out automatically like this, participants should know that the check they receive will add to their taxable income and be subject to a 10% early withdrawal penalty unless they left their job after reaching age 55. Generally, the early withdrawal penalty applies until the account owner turns 59 ½, but there is a special exception for employer plans that eliminates the penalty at age 55 for workers leaving their job after reaching this milestone.

Leaving the old 401(k) where it is makes sense if the plan offers enough investment options to build a well-diversified portfolio and the plan expenses being paid by participants are not too high. When the ability to make backdoor Roth contributions needs to be preserved, keeping the old plan intact may be the best option as well. This option preserves the ability to take advantage of tax-deferred compounding of investment returns.

Old 401(k) balances can also be moved to a new employer’s 401(k) plan, assuming that incoming rollovers are allowed by the new plan. Unless the investment options in the new plan are limited, more expensive, or have less attractive returns, this may be an excellent choice as it can preserve tax-deferred growth avoiding immediate tax on a withdrawal, and the ability to do backdoor Roth contributions. To avoid mandatory 20% withholding on the old 401(k) withdrawal, these moves should be handled as direct rollovers or trustee-to-trustee transfers so that the account owner never takes control of the funds.

401(k) and other retirement accounts can also be moved to traditional IRAs. Often, this is the preferred option because it allows for a wider array of investment options than most 401(k)s. In addition to comparing available investment options, it also pays to compare costs associated with the old 401(k) and an IRA. When moving old 401(k)s to an IRA, it is also best to use trustee-to-trustee transfers to avoid the mandatory tax withholding and glitches that might occur when taking possession of the 401(k) funds and re-depositing them in an IRA within the 60-day rollover period.

Another option is to rollover the 401(k) plan to a Roth IRA. This will trigger tax on the amount moved from the 401(k) to the Roth account, but the tax penalty is avoided and future earnings in the Roth account can be withdrawn tax-free if holding period requirements are met. Again, use a trustee-to-trustee transfer to avoid tax withholding on the withdrawal from the 401(k).

All of the above options are likely preferable to the last approach – cash out the plan balance. While it may seem palatable to incur the tax hit that comes from the additional ordinary income and the 10% early withdrawal penalty if under age 59 ½, the loss in investment returns can leave one’s retirement seriously underfunded.

David T. Mayes is a CERTIFIED FINANCIAL PLANNER ^TM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at (603) 926-1775 or david@threebearings.com .

This article originally appeared on Portsmouth Herald: Money Talk: What to do with your retirement plan when changing jobs