If and when you leave your employer, “take your retirement with you.”
This is a piece of conventional wisdom that makes some sense. When you leave an employer, you should make sure that your 401k or 403b follows you (assuming you have one). There are two ways that you can accomplish this – one is good and the other is pretty bad. Before we go any further though, it is important to understand your previous employer’s legal requirements.
Is your old 401k worth at least $5,000?
This is an important figure. If your 401k balance (less rollover amounts) is less than $5,000, then your old employer is legally allowed to cash it out and send you a check without your permission. Typically, old employers will send notification before they do this, however they are not required to.
If your 401k balance (less rollover amounts) is equal to or greater than $5,000, then your old employer is required to follow your directive.
While you can in most cases keep your 401k with your old employer, it is smart to take your 401k with you. Not because your old employer can steal your money – your 401k is your property, not theirs. Not because you are worried about your old employer going out of business – your 401k will not be in any way compromised in such an event. It is smart to take it with you because it is your money and it will be much tougher for you to keep an eye on it while it is over there.
Like I said before, there are two ways you can take your 401k money with you – one good, one bad.
This is the good methodology. What you do is contact your new 401k administrator, or you open a new Individual Retirement Arrangement (IRA), and complete a direct transfer form. This will allow for the money in your old 401k to be electronically transferred to the new 401k or IRA. It is a very simple form and very simple process. No withholding. No penalties. No worries.
It does not matter if you initiate the cash out or if your old employer does it, it all works the same. When your old 401k is cashed out, you will be issued a check worth 80% of the original value (the 401k administrator is required to withhold 20% and send to the IRS). At this point, you have 60 days to put 100% of your 401k’s value into an IRA. This means that you will have to fund the missing 20% out of pocket! If you do not successfully complete the transfer to the IRA, then the IRS will consider this an early withdrawal and you will be required to pay ordinary income taxes on the amount, plus a 10% penalty. There are exceptions to this rule, however we will not get into that here.
Now onto the real point of this post…
So what should you do about small 401k balances? And by “small,” I mean less than $1,000.
This is tricky. There are very few companies who will open rollover IRA’s for amounts less than $1,000. Most of the “good” IRA companies require a $1,000 minimum. The companies that will open smaller rollover IRA’s are far and few between (credit unions, some banks, Scottrade, and Schwab to name a few).
Could I cash out my 401k to cover some up-coming expenses?
If you have up-coming expenses such as medical bills or schooling, then cashing out the 401k money may seem like a good idea. Especially since the taxes and penalties on a small 401k balance will not be that much (in terms of dollar amount).
I personally would never do this, however this is where I will say “to each their own.” Unfortunately, options are limited with small 401k’s, so cashing out is understandably attractive.
One thing to keep in mind – if you have medical expenses that exceed 10% of your adjusted gross income, then you can qualify to have the 10% penalty waived.
Otherwise you may want to consider a different route. Cashing out a 401k to cover some expenses could be equated to borrowing at a 25%+ interest rate. Even though taxes will be paid on the 401k balance at some point in time, taking a 25%+ hit to pay an expense is really not a good idea.
It is all up to opinion at the end of the day.