Don't Hesitate; Shift the 401(k) Money Directly to IRA Account

Posted: May 22, 2006 5:21 PM

It's only human nature to postpone unpleasant chores. Some are easier to put off than others. While there are obvious consequences to not emptying a diaper pail, there may appear to be no downside to leaving your 401(k) alone when it's time to clean out your workplace cubicle and move on.

But for most people who choose this path, the consequences are far more hazardous than smelling stinky diapers. When you choose to strand your money in an old 401(k), you are limiting your loved ones' future inheritance options and you can also be jeopardizing your own investment returns.

If your money remains parked in your 401(k), 403(b) or 457 plan, its value will plummet if certain family members ultimately inherit what's left. Suppose, for instance, that a father leaves his 401(k) to his daughter. If the daughter is financially savvy (or has read my two previous columns on the virtues of inherited IRAs), she'll want to stretch this retirement account over her own lifetime.

She'd do this by leaving the money nestled in its tax cocoon and withdrawing only the amount that the Internal Revenue Service would require each year based on her life expectancy.

This may sound like a great idea, and choosing this route is OK with the IRS. As a practical matter, however, nearly all workplaces would politely tell the daughter to take a hike. Companies don't want the hassle of indefinitely handling the 401(k) of a dead worker, even if he earned a bunch of employee-of-the-month plaques.

An employer, who doesn't give a hoot about stretching IRAs, would be free to cut a check to the daughter. The daughter would pay income taxes on the windfall and the tax protection on the remaining cash would be shredded into confetti.

You may have noticed that I used a child and not a spouse for my example. Husbands and wives do enjoy an option that will prevent the workplace plan from splattering. Only a widow or widower can transfer the money from a deceased spouse's workplace plan into an IRA, where the money can remain protected from taxes.

If you need another compelling reason to roll your 401(k) cash into an IRA, here it is: By doing this, you may dramatically enhance your investment returns. You see, many - if not most - 401(k) and other workplace plans are stuffed with mediocre investments that pass along outrageous fees. Working stiffs, however, assume that their workplace accounts are free, so it's rare to find an indignant employee who rails at paying for caviar and receiving kibble instead.

Workers, by the way, aren't aware of being gouged because expenses are withdrawn from workplace accounts automatically. If people started receiving bills for their pathetic funds, maybe we could expect some revolts.

Even if your workplace plan isn't picking your pockets, moving the money into an IRA is a better option because it frees you from continuing to invest in a cramped list of funds. Millions of people are stuck choosing funds from a short lineup that someone in corporate might have approved on an off day.

Sometimes the dreadful funds are hand-picked by a stockbroker, who happens to play golf with the boss. If you establish an IRA rollover at a financial institution, you can select inexpensive mutual funds that work best for you. If I had that opportunity, I'd stick exclusively with index funds and exchange-traded funds.

Lots of things can go wrong when retirement money is in transit, so when it's time to move the cash, pretend that your account is a Faberge egg. What you should absolutely avoid doing is having your employer mail you a check. If you choose that route, you've got 60 days to get that money into an IRA rollover. This might not sound difficult, but countless people blow this simple task. If that check doesn't make it into an IRA in 60 days, it's goodbye retirement account.

Instead, tell your employer you want the money moved in a direct trustee-to-trustee transfer. This way the cash is dispatched right to your new brokerage firm, bank or mutual fund company, without using you as a middleman.

Yet even then you should remain vigilant for possible screw-ups. Double check to make sure that the financial institution puts the money into an IRA and not in a taxable account. Catastrophic mistakes like this happen all the time and you certainly don't want to be one of the casualties.

Of course, most workers who leave their jobs end up taking the worst possible option. According to Hewitt Associates, a global human resources firm, 45 percent of departing employees grab their 401(k) cash and run. And the most financially irresponsible are employees in their 20s - 66 percent choose instant gratification.

You may have a better time resisting temptation if you appreciate how much even a modest 401(k) can grow over time. Suppose a 25-year-old moved $5,000 from her 401(k) into an IRA rather than spending it on a trip to Maui. If the account generated an 8 percent annual return for 40 years, she'd have more than $108,000 when she retired, instead of some faded photos of a sandy beach.

While an IRA is the very best place for your old workplace cash, it's often not a hospitable destination for company stock that's sitting inside your 401(k). Next week, I'll explain what to do with that.