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Related topics: jobs, retirement, 401k, financial planning, Jeff Schnepper

Remember the good old days when the big R-word was "rebate" rather than "recession"?

That was before your 401k retirement plan melted down to a 201k. That was also before your company was downsized and you lost your job -- or before you jumped ship to a company that didn't view the movie "Titanic" as a business plan.

In either case, you still have those 401k dollars with your old employer. What should you do with that money? Here are your five options:

Cash out

Rule No. 1 in retirement planning: Never touch your qualified money until you actually retire. Rule No. 2: The first rule doesn't count if your family is hungry.

If you need the money to live, take it. Your retirement savings fund will go down, and the distributions will be added to your income, to be taxed at your highest marginal rate. If you're under age 55, the Internal Revenue Service will hit you with a 10% premature-distribution penalty. You'll also lose all the future tax-deferred growth on your investment. And your old employer will withhold 20% of the distribution for federal tax payments.

At least the IRS doesn't take your firstborn child, although the vote in Congress was close.

If you are still with your company, consider a loan from your 401k rather than taking the money outright. You're paying interest, but it's to your own account, and there's no immediate tax or penalty. The danger is that if you leave the company (voluntarily or not), most plans require immediate payback of all outstanding loans.

The bottom line here is to make this your last choice for a source of funds. But if you need the money to live, you really don't have any other options. Withdraw only what you need, as you need it.

Liz Weston

Liz Weston

Leave the money where it is

Leaving your 401k in your former employer's plan, if the option is offered, allows your money to continue growing tax-deferred. It protects those assets from any attacks by creditors. You can make early withdrawals without penalty if you retire, quit or are fired at age 55 or after. You still have the option of borrowing funds from the account if necessary. There's no tax penalty for leaving the money alone. And you can always transfer the funds to another employer's 401k once you get a new job.

The downsides are potentially high fees and limited investment choices. But if you don't need the money immediately and you like the plan's investment options, this may be the way to go.

Just don't do it too often. If you have multiple accounts with former employers, things can get messy when you reach retirement age. Taking the appropriate minimum distributions may become convoluted and difficult. (Miss a required distribution and you owe a 50% penalty on the amount you failed to take.) Depending on the wording of the plan, your heirs may not be able to stretch out distributions. In this case, you'll want to consider the following.

Make a rollover to a traditional IRA

Wide investment choices and potentially lower fees make this an attractive option. The money isn't taxed when you move it. You continue to get tax-deferred growth. If you don't contribute any additional money to the account, you retain the option of transferring it to another employer's 401k plan in the future.

This option is attractive if you want more investment flexibility or want to consolidate multiple accounts. It's easier to monitor and manage a single account, and it simplifies required minimum distributions. Also, your heirs can take individual retirement account distributions over their lifetimes.

On the downside, you can't borrow against an IRA, and you normally have to wait until age 59 1/2 to take distributions without penalty.

Make a rollover to a Roth IRA

Is your adjusted gross income below $100,000 for the tax year of your Roth IRA contribution? Do you expect to be in a higher bracket at retirement? If so, rolling over your 401k to a Roth IRA may be your optimal choice -- if you can afford the tax hit.

When you roll to a Roth, you'll pay ordinary income tax on the assets converted.

But it's not as easy and clear as you might think. Consider the impact of the additional income on your tax return. For example, more income may make your Social Security taxable, decrease your personal exemption and reduce your total itemized deductions. And that's after they've taken hits from the 7.5% medical expense floor and the 2% floor for miscellaneous deductions. I suspect marginal tax rates will be soon, which might argue for doing the conversion soon if you qualify.

Here's what you get with a Roth IRA:

  • Tax-free appreciation.
  • Tax-free withdrawals for you and your heirs.
  • Freedom from minimum distributions.
  • Potentially lower fees.
  • Expanded investment choices, compared with a 401k.

Transfer to a new employer's 401k plan

When you find another job, you can transfer your 401k plan to your new employer with no tax consequences. Just as with your former 401k plan, you have protection from creditors, continued tax-deferred growth, the option of borrowing against the account and no 10% penalty if you wait to take distributions until age 55 or older.

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You'll have to make sure the new plan permits transfers and loans. Just because it's OK under the Internal Revenue Code doesn't automatically mean your plan allows it. That's also true if your heirs want to stretch out distributions.

Review the new plan's investment options and fees as well. You're electing to make a completely new investment. Understand what you're getting into and what kinds of handcuffs you're agreeing to wear.

If you have company stock

One final word on a concept the accountants call "net unrealized appreciation." If you have employer stock in your 401k, you get a special benefit. If such stock is transferred to a taxable brokerage account, you pay only ordinary income tax on the value of the stock at the time it went into your account (your cost basis). When you sell the stock, any appreciation over that basis is taxed at long-term capital gains rates, currently capped at 15%.

So not only do you defer the tax on the appreciation until the sale, but that tax is limited to the maximum long-term capital gains rate as well. Once you roll the assets into a traditional IRA, that potential benefit is lost. All subsequent withdrawals are fully taxed as ordinary income.

Jeff Schnepper is the author of the best-selling book "How to Pay Zero Taxes," which is in its 30th edition. He is a former professor of taxation, accounting and finance. Schnepper now has a full-time tax planning and legal practice in Cherry Hill, N.J. Click here to find Schnepper's most recent articles.