Retirement Account Rollovers

When an employee leaves a position to take on a new role at another company, they often do not know what to do with the money in their tax-deferred retirement account. Many holders of 401K or 403b accounts are unsure as to what to do with the funds within these accounts. The information that both their new and old employer gives them about what to do is often unclear - most have no idea that making an incorrect decision can costs them literally hundreds of thousands of dollars in the long run. On top of this, there is a growing industry of financial advisors and institutions that have become aware of this group of individuals that on an annual basis have literally millions, if not billions of dollars available that they can solicit business from. The question an account holder faces is which option should they take to protect their nest-egg?

There are several different options that a 401k holder has in trying to decide what to do with money they have saved in their 401K, or 403b account. The first one, and probably the most common one, is to simply cash out the account. This is probably the most harmful move financially that an employee can make. By cashing out the account, many employees do not realize that they face severe financial penalties. Not only do they have to pay 20% income tax on that money based on their current tax rate, but if they are under the age of 59 1/2, they also have to pay an additional 10% tax penalty. If they are in a state that has a high income tax rate, a retirement account holder can lose close to 40% of the value of their retirement account just by cashing it out. If an employer has given matching funds towards any employee contributions, but those contributions are not vested, the amount cashed out can be reduced even further.

Some people also decide to use the money in their retirement account to payoff debts. This also is not a good idea. If someone becomes overburden with debts, it actually might be better for them to file bankruptcy rather than use their retirement account for paying debts. For one, retirement accounts are exempt from bankruptcy hearings. Secondly, the amount people stand to lose by starting all over in a retirement account can be substantial (see example below)

In some cases, such as a layoff by an employer, if an account holder has no other source of income, then they may well have to use money from their retirement account to get by until they can gain some other income source. But it is always best to keep hands off of this money until it is needed in retirement. If the money does have to be used, the 401K holder should note that if they come into additional money, they have 60 days to roll the money into a tax-qualified product in order to avoid these tax charges.

Another option is to cash the money out, and put it in a bank rollover IRA, or Individual Retirement Account. Many banks are offering and actively marketing IRA rollover accounts. They offer the safety that a bank provides, plus the ability to gain interest - usually in the form of a CD. However, what they do not do is offer financial safety over the long run. Bank CD rates often do not compare to the rates of return retirement accounts would receive if they were in a stock market -based product such as a mutual fund. Because of their lower rates of return, a 401K rollover account holder could potentially lose thousands of dollars in potential interest by putting their money in a bank IRA rollover account.

In addition to a bank IRA, there are other forms of IRA that allow for other types of investment products, such as mutual funds and stocks and bonds. These IRAs offer higher potential financial gains than a bank CD IRA. If choosing between the two, this form of IRA is the better choice.

One further option is to roll the money into a tax-qualified annuity. Annuities are what can be considered "reverse life insurance" - they are traditionally used to pay people money not after they die, but before they die. Usually, an annuitant receives monthly payments until they pass away. There are several different versions of annuities, but a deferred annuity product allows the money to grow until the annuity holder is ready to have the money disbursed after a given period of time, usually at retirement. There are many different options as far as types of products and rates of return an annuity holder can receive. However, depending on the type of annuity, an annuity holder can be severely restricted in how much they can withdraw out of an account at any given time. They may face an early-withdrawal penalty if they try to withdraw the money early - this on top of the regular early withdrawal tax penalty and income tax they would have to pay.

A final option is to roll the money into another retirement account. If a retirement account holder rolls their money into either another 401K provided by a new employer, or into a rollover account they open with a financial institution such as a stockbroker, they can avoid early withdrawal taxes and penalties. In addition, they aren't starting over with their retirement nest egg.

As I've stated earlier, someone starting all over in saving for retirement is potentially losing a great deal by cashing out and using that money early for other thing, such as debt consolidation. Using the following example:

Owner A has a 30K balance in a 401K, and they contribute $3000 a year for 35 years with an annual rate of return of 8%. When they retire at the age of 65, they end up with a retirement account balance of $648,000.

Owner B is starting off with no balance. They also contribute $3000 a year for 35 years, with the same interest rate of 8% - but their retirement account balance is only $344,000.

Just by not spending that initial 401K balance, Owner A has increased their initial 30K to an additional 304K.

Retirement account holders have to make good decision regarding their retirement accounts. Making an incorrect one can affect them much more than they realize. By taking the time to make the right choice, they can not only protect themselves from additional short-term expenses; in some cases, they can help in insuring their financial future.