Avoiding Portable-Pension Potholes

Look before you leave.

That's the advice from financial experts if you're thinking about leaving your job. They're not talking about severance pay, but your 401(k) retirement plan.

A misstep "could be costly," says Mary Rudie Barneby, president of Delaware Investment & Retirement Services of Philadelphia, part of Lincoln Financial Group.

"Don't touch the [401(k)] money until you know exactly what you are doing, and why you are doing it," she says.

If you inadvertently take possession of the account, your employer might have to fork over a fifth of it to Uncle Sam in taxes.

You could also find yourself owing a 10 percent penalty.

The issue sounds arcane. But millions of workers now rely heavily on work-based accounts to fund their retirement.

For anyone leaving an employer - whether retiring, heading to a new company, or being dismissed - it pays to bone up on 401(k) rules.

401(k) plans are retirement accounts to which workers voluntarily contribute a portion of their pay. Employers, who sponsor the programs, often match employee contributions up to a certain percentage of their salary. At nonprofit groups, these are called 403(b) plans.

Ms. Barneby says job departers have three basic options:

1. Leave the money with your former employer. However, if the account is worth less than $5,000, the company can ask you to remove it.

If you leave the account alone, make sure the company is financially sound. And note that if it's bought, your 401(k) plan might be changed to your disadvantage.

2. Have the account transferred directly to a 401(k) or 403(b) plan at your new employer. Some companies, however, require that you must be employed for a certain period of time before you can enter their contributory plan. Typically, that is a year.

3. Transfer the account directly to a rollover individual retirement account (IRA).

You can also take a cash distribution, but that brings tax and penalty payments.

Company stock held in a 401(k) gets special tax treatment, which may favor avoiding rollovers into an IRA (see story, below).

The key to your planning is to keep yourself out of the way during any transfer process, Barneby says. The administrative work should always be between officials of your former employer and representatives of your new company or your new IRA.

If you make a direct transfer to your new employer, have the new company contact your former employer for a rollover.

If you are transferring into a rollover IRA, let the financial institution handle the transfer, try to have the check made out to the trustee of your new plan. If it's made out to you, don't cash or deposit it. Turn it over to the administrator of your new plan.

If you do take possession of your 401(k) account, your former employer must turn 20 percent of the total account over to the Internal Revenue Service in taxes. In addition, you must pay back the 20 percent or face a 10 percent penalty on the withdrawal.

An important note regarding withdrawals: Once you reach age 55, there are no tax penalties for withdrawals from a 401(k) if you leave your job for any reason. By contrast, if you take a withdrawal from an IRA, you must pay a 10 percent penalty until you reach age 59-1/2.

That means, then, that if you are 55 or over, you have the option of either taking penalty-free withdrawals from your 401(k) plan, or rolling the entire amount into an IRA and then waiting until you are 59 1/2 before you can take penalty-free withdrawals.

If you put your money into a new IRA, you have numerous options.

You could put it into more conservative investments, such as bonds or certificates of deposit, or into stock mutual funds, or a mix. Another approach would be to take out a self-directed IRA account with a discount broker. In such an account you can hold both mutual funds and individual stocks.

A final note: If you roll your 401(k) money into a preexisting IRA, or add new, non-401(k) money into a rollover IRA, you forfeit the option of later shifting the money to your new employer's 401(k), Slott notes.

Congress is currently considering several measures to ease the shift of pension packages from one employer to another.

But experts stress that even if such changes pass, individuals must still ensure that they are rolling over their accounts in a way that does not bring unnecessary tax penalties or loss of savings.

One suggestion: Check with your old or new employer before shifting your account to make certain you meet current legal requirements.