The Five Biggest 401(k) Rollover Mistakes
by David Bach
October 8, 2007

A couple of weeks ago, I invited readers to take part in my 401(k) savings challenge, and promised to keep the momentum going with more articles about making the most of your retirement plans.

401(k) Rollovers Uncovered

One of the topics many of you wanted to learn more about is how to make smart rollover decisions when changing jobs. Well, you're not alone. According to consultant Deloitte's most recent 401(k) Benchmarking Survey, 22 percent of employers surveyed revealed that their employees find rollovers to be the most confusing part of their retirement plan.

"Rollover" is the term used to describe moving money from one type of tax-advantaged account, like your 401(k) plan, to another, such as an individual retirement account (IRA) or a different 401(k) plan at your next job.

The goal here is simply to ensure that your money continues to grow tax-deferred and that the government is aware of its status. Otherwise, you're likely to get hit with a tax bill for funds you didn't want to receive until retirement, and possibly an additional penalty.

The Five Pitfalls

Here are five of the biggest 401(k) mistakes people make when changing jobs, and my advice about how to avoid making them yourself:

1. Cashing out.

The last thing you should do is tap into your retirement savings simply because you're changing jobs and you can. Yet according to Hewitt Associates, 45 percent of employees do this. What's worse is that 69 percent of employees between ages 20 and 29 cash out -- and this is the group with the most to gain from long-term compounding.

Let's not forget that this money has been earmarked for retirement, and that's why you get tax advantages. But when you break your agreement with Uncle Sam, he wants his payback. Not only will you be required to pay ordinary income taxes on any before-tax contributions and investment earnings you receive, you'll also have to fork over an additional 10 percent tax penalty if you're under 55 (if your money is already in an IRA, the tax penalty applies until you reach 59-1/2).

To drive the point home, consider what happens at age 25 if you cash out a $5,000 balance. You'd receive a net amount of only $3,100 -- $5,000 minus 28 percent ordinary income tax ($1,400) and the 10 percent early-withdrawal penalty ($500). However, if you rolled over your original $5,000 and kept it invested until age 65 (assuming 8 percent annualized earnings), you could end up with more than $108,000 at retirement.

2. Leaving your money behind.

If you leave your job for a new one, don't leave your 401(k) money with your former employer. Why? When you leave a 401(k) balance behind, you run the risk of giving up control of your investments.

If you're out of touch with your old plan and they change mutual fund providers (from a Fidelity 401(k) plan to a Vanguard 401(k) plan, say, which is something that happens all the time), not only can your money be frozen during the transition, but it may default to the new plan's low-yielding money market fund or other investments you might not like.

It's also important to note here that just because your new employer offers a 401(k) plan doesn't mean you shouldn't consider rolling over your old account into an IRA instead. IRAs often offer you much more flexibility than a 401(k) plan with regard to investments, withdrawal options, and alternatives for your beneficiaries.

Employers aren't required to keep you on their books if you have a 401(k) balance under $5,000. However, rather than cashing you out, they must at least establish an IRA rollover for you with this money. If your balance is less than $1,000, you may still be cashed out of a former employer's plan.

Another strong argument for taking your money with you is that people simply tend to forget about old plans -- or worse, they die and their beneficiaries have no idea that the account even exists.

3. Not taking the "direct" route.

There are generally two ways to go about requesting a rollover: You can set up a direct rollover, where the funds are electronically transferred to a new plan or account you're establishing (or a check is drawn in their name). Or you can receive payment within a 60-day window in which to roll over the money.

The latter may sound like an attractive option to temporarily splash around in your retirement pool if you have short-term cash-flow needs. However, there are too many things that make it unattractive.

For one thing, you won't get a check for the full amount of your account balance. Employers are required to withhold 20 percent of the gross amount as a prepayment of your income taxes if the check is made out directly to you. So, if you're trying to roll over $10,000, you're only going to get a check for $8,000 -- and that means you have two months to come up with the additional $2,000. (You'll be reimbursed the $2,000 when you file your federal income taxes.)

If you miss the deadline, then the whole amount is considered a taxable distribution. You'll have to add another $10,000 onto your taxable income for the year and pay income tax on that amount. If you're under 55, you also get hit with the 10 percent early-withdrawal penalty.

So, if at all possible, avoid ever having a rollover check made out to you. Some employers may only offer you the option of sending the check to you, but make sure to have it made out to your new financial institution -- so there are no withholding requirements -- with an "FBO" ("for the benefit of") naming you. For instance, my check might be made out to "Morgan Stanley IRA Rollover FBO David Bach."

There's more about the rules for rollovers here.

4. Making hasty decisions regarding company stock.

When making your rollover, you might just assume that you'd sell all the investments in your account and invest the proceeds in new investments offered by your next provider. But I recommend you think twice about this when you have company stock in your account.

First, you may not be able to control the exact date when your stock is sold. As a result, you might not get the best sale price. While selling the stock when it's still in your 401(k) plan can help you avoid paying broker commissions, it's best to have control over the timing of the stock sale and elect to move the company stock "in-kind" (as stock shares) into the new rollover account.

In the long run, however, you can often do even better if you transfer your company stock in-kind to a taxable account instead of rolling it over. Unlike other investments in your company's retirement plan, shares of company stock may be eligible for special tax treatment after you leave your employer. This is due to something called net unrealized appreciation (NUA), and can work in your favor if you're holding company stock that's greatly appreciated.

In short, NUA is a strategy that allows you to take advantage of the lower long-term capital gains tax rates versus your ordinary income tax rate when cashing in stock upon leaving an employer. Using this strategy, you can take a lump-sum distribution of company stock (transferring it to a taxable account in-kind) and pay the ordinary income taxes on the stock's cost basis, plus the 10 percent penalty if you're under 55.

5. Going it alone.

Finally, if you're unsure of what the best move is for your individual situation, seek the advice of a professional tax adviser, money coach, or financial advisor.

After all, this is your retirement nest egg we're talking about. It took you years -- if not a lifetime -- to accumulate it, so don't take chances with it now.