Leaving a job where you have a 401(k) plan can lead to paying income taxes on your retirement savings prematurely if you don't play your cards right. Withdrawals from 401(k)s are considered ordinary income, so cashing out when you leave your company means you'll pay taxes and possibly an early withdrawal penalty. You can avoid this financial hit by moving your money to an individual retirement account, but you may still owe taxes if you don't roll over all of the cash.
401(k) and Taxes
Money you put into your 401(k) plan comes directly from your paycheck before income taxes are taken out. Since your 401(k) savings are shielded from taxes in the year you contribute, you must pay when you take the cash out. A 10 percent early withdrawal penalty also applies to funds you tap before age 59 1/2. If you leave a job in or after the year you turn 55, the penalty does not apply.
It is possible to transfer your cash from a 401(k) to an IRA directly to avoid taxes and penalties. With a direct transfer, you tell your IRA provider to contact your old employer to have your 401(k) money transferred into the IRA, without distributing any of it to you. Since you never receive the cash, you never make a withdrawal, so you aren't taxed or penalized on the transfer. Money in a traditional IRA is subject to the 10 percent early withdrawal penalty if you tap the account before 59 1/2.
401(k) to IRA Rollovers
If you choose to have your 401(k) distributed to you, you can still avoid taxes and penalties by rolling it over into an IRA. To complete a 401(k) to IRA rollover, you have to deposit the cash you receive from your 401(k) into an IRA within 60 days. If you don't, the taxable part of the withdrawal that is not rolled over is subject to income taxes and possible the early withdrawal penalty. When you receive a check from your 401(k), your old employer is required to withhold 20 percent for taxes. You must come up with the shortfall from another source to complete the rollover without paying any taxes.
A Roth IRA is a special type of IRA that lets you withdraw funds tax-free during retirement. But here's the rub: You have to fund a Roth with after-tax dollars. Since cash in a 401(k) is pretax savings, you can't transfer money from a 401(k) to a Roth IRA unless you shell out income taxes on it.
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