Tuesday, June 7, 2011

Leaving your employer…What to do with your 401(k)?

If you are leaving your employer with whom you have a 401(k), you may want to carefully consider what you want to do with the 401(k). I have done many tax returns where clients cashed out their 401(k) and ended up paying more income tax at the end of the year.  Here is generally what happens.

Cash Out:
You leave you employer, for whatever reason, and take a lump sum distribution of your 401(k). Let’s say the value is $100,000.  But, you receive a check for $80,000 because the plan administrator tells you that they are withholding 20% of the taxable distribution. What many people don’t realize is that $20,000 is just a payment towards your tax bill. Your tax bill is not necessarily paid in-full; it’s going to depend on your total income and deductions for the year.  
In many cases adding $100,000 to someone’s income is going to place them in a 28% to 33% tax bracket.  Remember, the plan administrator only withheld 20%, so you are probably going to have to write a check for the deficiency. 

If you are younger than 59 ½, then you may be subject to a 10% penalty on the distribution. There are exceptions to the penalty, so you should ask your plan administrator, or financial advisor if you qualify for any of the exceptions before you take the distribution.  In this example, $10,000 (10% * $100,000) would be added to you tax bill just for taking a cash distribution.


Leave it There:
Many plans allow you to leave you 401(k) with them, if its value is above a certain amount. If you have been happy with the funds’ performance, this may not be a bad option. Usually fees within a 401(k) are low.

Rollover:
Another option is to rollover the 401(k) into either a traditional IRA or a Roth IRA. If you use this option, consider using a “Trustee to Trustee” transfer. In other words, you first setup the IRA account then tell the two plan administrators that you want to rollover your 401(k) into an IRA. So, you never take the distribution. In this way you can avoid potentially making an unintended taxable distribution.    

Brycast Financial Planning in Austin Texas --- We Can Help
Income Tax Preparation in Austin Texas
Enrolled Agent; Investment Advisor

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