What is a 401K rollover?

If you are lucky enough to have an employer that offers a 401K plan, hopefully you are taking advantage of it, especially if they offer employer matching funds. Unlike pensions of the old days, where your employer put aside money to pay you a pension when you retired, 401K plans are retirement savings plan that you own, where you contribute pre-tax income -- and hopefully your employer will match part of your contributions to increase the value of your account. Some employers match your contributions up to 5 or 6% of your total income, some match 50% of your contributions -- they can contribute as much or as little as they want. Think of any employer match as free money -- a 50% match on your contributions equals an instant 50% return on your investment, which is hard to match anywhere. 401K accounts are tax-advantaged, in that contributions you make today are deducted from your income -- you pay no income taxes on the money you put into the account today. And your money in the account grows tax free as long as it is in there. But the government doesn't like to miss out on taxes forever -- the hitch is that when you withdraw the money in retirement, you finally pay taxes on it then. Ideally, you are in a lower tax bracket at that time, but there is no guarantee of that. And if you take the money out early (before the age of 59 1/2) you pay a 10% penalty on any withdrawls.

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And that brings us to the topic of 401K rollovers. If you leave a company that had a pension plan, you had to wait until retirement age to see any of that money, when the company would start sending you monthly checks. With a 401K account, you own the account, and when you leave a company, you can take it with you -- it's your money, not the company's. So the question is, what is the best way to handle your 401K account when you switch jobs? Some companies administer there own 401K plans, others hire financial firms to do it for them. One option you have when you leave a company is just to leave the money there -- they will continue to send you quarterly statements, and tehy will begin disbursing the money once you reach the required age levels. But lets say you change jobs 7 times over 30 years -- you could end up with 7 different 401K accounts at seven different companies, which could be a bit of a hassle to deal with. The other option a lot of people take is to have their 401K plans cashed out when they leave a company, thinking of it like a bonus. But this is a big no-no, for several reasons. First, this was meant to be your retirement income, and you just spent it on a car and vacation when you changed jobs -- OOPS! Second, the money put into the account was not taxed, and when you take it out, it is taxed -- plus you get hit with a 10% penalty. So perhaps you had an account balance of $68,000, but by the time you get a check from your old company minus tax withholdings and penalties, you might see only half that money, in this case $34,000 -- that's a big tax hit, and a lot of money down the drain. So let's start with that first piece of advice -- when you switch jobs and leave behind a 401K account, DO NOT BE TEMPTED TO WITHDRAW THE MONEY! Either leave it there with the plan administrators or do a 401K rollover -- which means putting the money into an IRA (individual retirement account) at another financial institution.

401K Rollovers

Basically, 401K plans and IRA accounts are the same thing -- they are retirement savings accounts funded with pre-tax income (except for ROTH IRAs), which are taxed when withdrawls are made, and penalties are paid on early withdrawls. The main difference is that 401K plans are sponsored and administered by employers, while IRAs are setup and managed by individuals, hence the "I" in the IRA which stands for "Individual". Just like you can set up an IRA for yourself and contribute to it each year, you can also take your 401K account when you leave a company and roll it over into a new or existing IRA account. You also have the option of rolling your 401K into a 401K at your new employer. Most financial institutions can help you set up an IRA or a 401K rollover -- banks, investment companies (Fidelity, Vanguard, etc.). Visit their websites or a retail office if you need info on setting up an IRA or rolling over a 401K. There is usually a few forms to fill out, then they will arrange for the transfer of your 401K from your old employer and into your new or existing IRA account -- voila, you have "rolled-over" your 401K. But you will want to make sure you follow the proper rules and procedure for doing this to avoid having taxes withheld or penalties paid. Many times your employer will give you a distribution form to fill out upon leaving the company -- you can choose to leave the funds there in their plan, roll the 401K into a new 401K at your new employer, have the funds distributed to you (called a lump-sum distribution), or transferred to another financial institution retirement account. In most cases, you should never have the funds sent directly to you -- if you do, the company is forced to withhold 20% for taxes and you may be subject to penalties as well, though the IRS allows a 60 day window to properly fund and deposit to an IRA account and get the 20% back (this is called an indirect rollover). So if you want to take your money with you and put it in a new IRA account, make the arrangements, fill out the forms correctly, and have the money transferred directly to the new IRA and not to yourself.

More Information on How to Do a 401K Rollover

Most of the big financial companies offer online information on how to rollover your 401K. As an example, check out Rollover.TRowePrice.com. They explain the benefits of rolling over your 401K, they show you what to do if you have already received a lump-sum distribution check (indirect rollover), and cover all the rollover options (as listed above). If you are ready to arrange your 401K rollover, just follow the steps shown. We just listed T Rowe Price as an example, but you can do the same with Schwab.com, Vanguard.com, Fidelity.com, etc.

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