Money Talk: Know the rules to avoid neglecting your old 401(k)

In today's work force, 401(k) plans and frequent job changes have replaced pensions and long careers at a single employer. This job mobility could lead to a less secure retirement if workers do a poor job of overseeing their 401(k) plan balances as they jump between employers. Recent surveys suggest many workers are unsure of what to do with their old company's 401(k) balances after a job change and some even forget about these accounts altogether.

If 401(k) plans are to replace pensions as a source of retirement income, workers will need to take better care of them, keeping track of their balances as they change jobs and avoiding the temptation to take the money and run with each career move. Cashing in an old 401(k) is the worst of several options available for handling old balances. Pocketing the funds means years of lost account growth and triggers immediate income tax on the entire amount. Workers under age 55 will also need to tack on a 10 percent tax penalty unless an exception applies.

To keep an old 401(k) growing tax-deferred for retirement, there are three basic options: Leave the money where it is, transfer the funds to a new employer's 401(k), or complete a rollover to an Individual Retirement Account. Each of these options has its own pros and cons. For some workers, leaving funds in an old plan may be a conscious choice, rather than indecision. Investment options in 401(k)s are generally limited, but larger plans may provide access to unique accounts that are unavailable through an IRA. Retaining access to these funds may require leaving the 401(k) where it is. Maintaining protection from creditors may also give advantage to the old 401(k). Federal law extends creditor protection to all 401(k) accounts. Creditor protection for IRAs is governed by state law, and not all states extend this shelter to IRAs. Workers leaving a job after age 55 may also favor keeping their old 401(k) in place to take advantage of a special rule that provides for penalty-free distributions after age 55 and before age 59½. Distributions from traditional IRAs are subject to a 10 percent tax penalty tax if taken before age 59½.

If early access to funds might be required, keeping the 401(k) in place may be preferable to completing an IRA rollover. Rolling your old 401(k) plan balance into your new employer's plan may also be an option if the new plan accepts incoming transfers. This approach consolidates accounts for easier tracking, keeps the funds growing tax-deferred for retirement and keeps open the option of borrowing from your plan balance if needed in a cash crunch. 401(k) plans can offer a loan provision allowing participants to access 50 percent of their plan balance up to $50,000. Loans are not available from IRAs. But, before pursuing this approach, be sure to evaluate the new plan's investment options carefully. If the investment alternatives are limited, expensive, or both, the scales may tip toward rolling your plan balance to an IRA so you can build a portfolio more suited to your retirement goals.

For maximum control and investment flexibility, rolling an old 401(k) into a traditional IRA account is the best alternative. Be sure to request the rollover be completed as a trustee-to-trustee transfer rather than having a distribution made payable to you. While you can complete a rollover by taking a distribution and depositing the amount into an IRA within 60 days, your employer must withhold 20 percent of the distributions for taxes. This means that, in order to roll your entire account balance to an IRA, you must have other funds available to make up for the 20 percent sent to the IRS. If not, the amount withheld will be considered a distribution and subject to ordinary income tax and the 10 percent early withdrawal penalty. Keep things simple and have the distribution check made payable directly to your new IRA rollover account.

For more information on IRA rollovers, see IRS Publication 575, Pension and Annuity Income. Knowing rules for handling old 401(k) plan balances will help you avoid neglecting these orphan accounts and leave you better prepared for retirement.