Did You Leave Your 401(k) With an Old Employer?

A friend told me today that her brother left his job a while back to start his own business, but his retirement money still was sitting in a 401(k) account with his former employer. She wanted to know if he should just cash it out.

"No, that's a bad idea," I said because he would have to pay a 10% early-withdrawal penalty and taxes. A better idea would be to roll the money directly into a traditional IRA or Roth IRA (see Yes, You Can Roll Over a 401(k) Into a Roth IRA).

Because my friend's brother is self-employed, he also could roll his 401(k) over into a SEP IRA or solo 401(K ), With a solo 401(k) You also can borrow up to half of your account balance (but not more than $50,000) -- something you can't do with any IRA. See Retirement Accounts for the Self-Employed to learn more about the rules and how to open an account.

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Benefits of rolling over your 401(K). If you cash out your 401(k), the distribution will be taxed as ordinary income, in your top federal tax bracket (except to the extent you made after-tax contributions). You'll also pay a 10% early-withdrawal penalty if you're younger than 55 in the year you leave your job.

For example, if cash out a $10,000 balance you'd pay up to $3,500 in federal taxes and penalties if you're in the 25% tax bracket. But there's more to consider than the immediate tax loss. Cashing out will also cost you thousands of dollars in foregone compounded interest.

If you roll your 401(k) over to an IRA or solo 401(k), you can avoid the tax bill and your money will continue to grow for retirement. Plus, you'll have greater control over your money. You can invest in the stocks, bonds or mutual funds of your picking -- not just the limited choices in your fromer employer’s 401(k).

Many mutual fund companies will let you open an IRA online. Or you can call a fund company, and most will walk you through the roll over process step by step. Vanguard and T.Rowe Price are good fund companies to consider because they have super low fees.

Once the IRA is open, tell your former employer you want a "direct rollover," where the employer transfers your 401(k) funds directly to your IRA so you can avoid taxes and penalties. If the check is made out to you, your former employer must withhold 20% for income taxes -- and you could get stung by a 10% early-withdrawal penalty if you're younger than 55 and don't get the full amount of the distribution (including the amount withheld for the IRS) into an IRA or other retirement plan within 60 days.

When it makes sense to leave your 401(k) as is. If you retire or get laid off between ages 55 and 59½, you could be better off leaving your money in your former employer's retirement plan. That's because you can take penalty-free withdrawals from a 401(k) if you're at least 55. You can't withdraw money from an IRA penalty free before age 59½.

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