Cents and Sensibility Guy Steele

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Why departing workers should not cash out 401(k)s

IF you leave your job, what should you do with the money you've accumulated in your 401(k)? Many of your fellow 401(k) owners are making hasty decisions, which are proving to be quite costly. Consider this statistic: 45 percent of departing workers cash out their 401 (k) plans, according to a recent study by Hewitt Associates, a consulting firm that administers companies 401(k) plans.

Why shouldn't you "cash out" your 401(k) when you leave your job? Here are two reasons:

» You'll face a tax hit. You will pay income tax on the money you receive. Your employer is required to withhold 20 percent of your 401(k) balance when you cash out your plan. The amount of tax you actually pay may be more or less, based on your marginal tax rate when you file your tax return. Plus, you may have to pay an additional 10 percent penalty tax if you are not 59 1/2 and qualify for one of the limited exceptions.

» You'll lose opportunities for future growth. If you cash out your 401(k), you may lose out on the biggest benefit of the plan: tax deferral. Suppose, for example, that you are 35 years old and your 401(k) is worth $50,000. If you cashed out your plan, you'd have to pay the taxes right away on this amount, plus a 10 percent penalty tax, and you may be tempted to spend the rest. But if you moved the $50,000 to a tax-deferred vehicle that earned 7 percent annually, your money would grow to more than $380,000 after 30 years, even if you never added another cent to the account.

You have some alternatives to cashing out a plan. Let's look at the most popular ones:

» Move your money directly into an IRA: If you move your 401(k) into a "Rollover IRA," your investments continue to grow on a tax-deferred basis, and if you rollover the amount directly to your IRA, you will avoid the 20 percent federal withholding. You can withdraw money as you need it, subject to IRA minimum distribution rules, which apply at age 70. You'll pay income tax only on the amount you withdraw. (If you make withdrawals before you reach 59 1/2, you may be subject to a 10 percent penalty.) Plus, you can fund your IRA with many types of investments: mutual funds, stocks, bonds, government securities, etc.

» Convert your 401(k) into a qualified annuity: Your 401(k) plan may allow you to use your assets to purchase a qualified annuity. Your investments continue to grow on a tax-deferred basis, and you can eventually take payments in the form of a lifetime income stream.

» Move your money to a new employer's plan: If you're changing jobs, and your new employer offers a 401(k), you may be able to transfer the funds from your old plan to the new one. You'll still benefit from tax deferral, and you may like the investment choices available in the new plan.

» Leave the money in your plan: Not all 401(k) plans offer this option. You will have to start making withdrawals by age 70 1/2.

Which of these choices is right for you? It all depends on your individual situation. But, as a general rule, all of them would probably be preferable to cashing out your plan. So consult with your tax adviser, talk with your investment representative and consider your options carefully.