Financial Planning

New 401(k) rules have been released and they pertain to how the balance in an employee’s retirement planning account will be distributed upon termination of employment.  The new rules actually create a convenience and will save many former employees quite a bit of money. However, there are alternative methods of handling these balances that could save them even more.

Under the previous rules, an employee who had less than $5,000 in his or her 401(k) account was required to roll over the money into an IRA within a certain period. If this was not done, employers distributed 401(k) account balance, deducting 20 percent federal income tax withholding. Employees who kept the money would then owe income taxes on the full amount and a 10 percent early withdrawal penalty if under age 59 ½.

The new rules require that employers roll 401(k) balances of $1,000 to $5,000 into an IRA, while accounts with balances of less than $1,000 will be cashed out. This automatic rollover will save many departing employees almost 40 percent of their account balance that would previously have been allocated to taxes and penalties. Aside from the immediate tax loss, the compounded interest lost due to cash out could have run in the hundreds of thousands of dollars.

Though this new rule is great news for many employees planning to leave their jobs, those who change jobs on a regular basis may want to explore the alternative of opening up their own rollover IRA. Rather than having five separate IRAs from five former employers, they can directly roll each 401(k) balance into the same rollover IRA.  If the new employer’s 401(k) plan accepts transfers, that is another option to be investigated.

Some consultants feel that cashing out a 401(k) when moving from employer to employer is the top reason many people will not have enough money during their retirement years. The new 401(k) distribution rule addresses exactly that problem by automatically rolling certain balance amounts into an IRA. Recently departed employees may also want to explore the options of opening up a Rollover IRA or transferring the balance from the previous employer’s 401(k) account into the new employer’s plan.