401(k) choices when you change jobs

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Q. My son is switching to a new job and he’s thinking of taking the money out of his first 401(k) to help pay moving costs. I’m saying it’s a bad idea. Can you help me explain why?
— Dad

A. Prematurely withdrawing money from a retirement account such as a 401(k) can be very costly.

If he takes the money out of the 401(k) he will have to pay income taxes and a 10 percent penalty on the funds, said Roy Williams, president and founder of Prestige Wealth Management in Flemington and Millburn.

To offer an example, Williams is assuming your son is in the 15 percent tax bracket.

“If he had $1,000 in the 401(k) and he takes it out, he would only walk away with $750,” Williams said. “If he instead left it in the 401(k) or an IRA for the next 40 years until retirement, at an annual growth rate of 7 percent he could have over $14,000.”

He says you should remind him that while retirement is still 30 or 40 years away, the sooner you start saving, the sooner you can retire.

Now that he’s left this job, he has several other options for the money.

He can, for now, do nothing.

“As long as he contributed $5,000 to the plan, he can leave it in the current 401(k),” Williams said. “When he gets another job the new plan typically allows participants to rollover any former 401(k)s or IRA accounts into that plan.”

That would give him all his money in one account.

Another option is to contact the custodian who holds the 401(k) and direct it to make a “trustee to trustee rollover” to an IRA account.

He can open an IRA at any custodian, Williams said, from a bank to an FDIC or SIPC-covered brokerage firm.

“To get him interested let him know he can then invest in companies that he likes – Apple, Under Armour, Tesla,” he said. “Additionally, if he were to use the money to buy a home, an IRA allows you to avoid the 10 percent penalty tax on the first $10,000 you withdraw from the account for a first-time home purchase.”

Another option is to convert the money into a Roth IRA.

This may make sense if his income is low enough, maybe 10 percent bracket or lower, Williams said.

Typically this will be a two-step process: He’d first transfer the 401(k) to a traditional IRA, and then immediately convert the funds from traditional IRA to a Roth IRA.

“You will pay income taxes on the funds now — but no penalty — but you won’t pay tax on any withdrawals in the future based on current tax laws,” Williams said.

Best of luck and remember to keep saving!

Email your questions to moc.p1603173150leHye1603173150noMJN1603173150@ksA1603173150.

This post was first published in October 2016.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.