Money in a tax-deferred, employer-sponsored 401k retirement plan remains yours even after you move to another employer. As of August 2010, more than 15 million 401k accounts were left with former employers. You have three options for handling your 401k from a former employer. The tax and penalty consequences depend on which option you choose, and whether you are at least age 59 1/2.
Cash It Out
You can cash out the 401k of your former employer by taking a lump-sum distribution of your account funds. But if you do, you will owe income tax on the entire amount distributed in the year the money was paid to you. There is no way to avoid income taxes when you cash out. If you are younger than 59 1/2, you will also owe a 10 percent penalty tax on the amount of your early distribution. By cashing out your account, you also give up the opportunity for further tax-deferred compounding of your earnings.
If the distribution is paid to you, the fiduciary administering the account must withhold 20 percent of the distribution for taxes. You can escape the early-distribution penalty if your early distribution was made under an annuity arrangement, or if you become disabled, or if you had medical expenses exceeding 7.5 percent of income, or if the money was paid to an ex-spouse under a divorce settlement. But you will still owe income taxes on your early distribution regardless of the reason.
Leave It Alone
You can choose to leave your money in the former employer’s 401k plan. That plan will continue as before, except you won’t receive any more contributions from your former employer. There are no tax consequences for leaving your money in a former employer’s 401k until retirement.
But if the account has less than $5,000, the plan administrator can elect to cash you out and send you a check for the proceeds less the mandatory 20 percent withholding, or to transfer the funds to an individual retirement account of its choosing. The former employer may charge you an account management fee. And if your former employer went out of business, merged or otherwise underwent a major business change, you might have difficulty finding out how and where to get funds from your 401k.
Roll It Over
You can roll over the money from your former employer's 401k into your current employer’s 401k plan, or into your own tax-deferred IRA. This involves no withholding, income taxes or penalties so long as you do the transfer by a direct plan-to-plan rollover.
If the rollover money is paid to you, you have 60 days to put it into a new tax-deferred retirement plan. The drawback is that the old plan administrator must withhold 20 percent of your distribution for taxes, and you will owe taxes and the early-withdrawal penalty on the withheld amount. You can avoid tax and penalty on the withheld amount if you replace it with other funds within the 60-day rollover tax window.
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