Know Your 401(k) Options

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Financial advisers have long fretted over the casual attitude investors have toward their 401(k)s, but now there’s a sign people are paying more attention.

Charles Schwab (Stock Quote: SCHW), the discount brokerage, says more investors are shifting their 401(k)s into other accounts, mostly IRAs, after leaving their jobs. Schwab says 69% of assets held by participants who left their job in the fourth quarter of 2008 were moved by the end of 2009. The year before, the figure was 57%.

Of the accounts that were moved, 80% of assets were rolled over into IRAs, up from 75% the year before. About 10% of the shifted assets were taken as cash distributions, and most of the rest was transferred into a 401(k) or similar plan with a new employer.

Schwab believes investor education and industry marketing has focused more investors' attention on managing retirement funds. Job losses have obviously played a role, too, giving more investors the opportunity to shift their funds.

Generally, money invested in a 401(k) cannot be withdrawn without incurring taxes and, if the investor is under 59 ½, a 10% penalty, so long as the investor works for the company sponsoring the plan. But when you leave your job, voluntarily or not, you have four options:

Staying put. Most companies allow departing employees to remain in their 401(k)s unless their account value is less than $5,000. Remaining in the plan is a good option if you like the investment choices. Former employees are not allowed to add to their accounts, and usually aren’t allowed to borrow against them.

Rolling into an IRA. This is the most popular option because IRAs offer a virtually unlimited array of investing options, while the typical 401(k) offers about a dozen mutual funds. You can choose any fund company, brokerage or bank you like, and can divide the money among various accounts if you like. There is no tax or penalty if the rollover is done directly from one account to another. The firm that will receive the funds can guide you through the process.

Transferring to a new 401(k). Assets can also be rolled into a new employer’s 401(k) without incurring tax or penalty. This can be worthwhile if the new plan offers investments you cannot get through an IRA, such as funds closed to new investors or fund classes with especially low fees. But once the money is moved into the new 401(k), it generally has to stay there until you leave your job or are eligible for penalty-free withdrawals. This is why the IRA rollover is often more appealing. Funds shifted to a new 401(k) may be eligible for loans, while you cannot borrow against an IRA.

Taking a cash distribution. In most cases this is the least-desirable option. If you are not 59 ½, you probably will face a 10% penalty. Even if you don’t, you’ll have to pay income tax on the withdrawal. In fact, the plan administrator will withhold 20% of your withdrawal for taxes, with any refund or additional tax to be sorted out in your next return. A cash distribution also deprives you of the benefits of tax-deferred compounding.

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