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I'll be receiving a lump-sum payment of $125,000 from my previous employer's 401(k). My current company does not have a 401(k) plan, nor any retirement plan for that matter. Where is the best place for me to put the money from my old plan?
-- James, Hanceville, Alabama
You're definitely thinking along the right lines. The main thing you want to do is preserve the tax-deferred status of the money you accumulated in your previous employer's plan.
Faced with the possibility of getting their greedy little mitts on a big chunk of cash that had been sitting in a retirement account, many people decide to take the money and run.
Of course, if you do that, you'll owe ordinary income taxes on the money from the old plan, not to mention a 10 percent penalty if you're under age 55 and not retired. You could also find yourself short of sufficient assets at retirement time too.
What are the options?
So what are your choices? Well, if your current employer had a 401(k) or other type of retirement plan that accepted rollover money, then you could simply transfer the stash to your new employer's plan (assuming you like the investing options in the new plan). But since your new employer doesn't have a retirement plan of any sort, that's not an option for you.
But there's another option you can easily take advantage of: roll your stash into an IRA rollover account. You can open an IRA rollover at virtually any bank, brokerage firm or mutual fund company. And by transferring the money into the IRA rollover, you avoid paying taxes on your accumulated savings, and your money continues to grow free of taxes until you withdraw it.
When you do the rollover, you want to take care to do it via what is known as a "direct rollover" or a "trustee-to-trustee" transfer."
Essentially, this means the trustee of your old 401(k) account should send your account balance directly to your new IRA account, although the administrators at your old 401(k) may opt for a variation of this process in which they send check to you that's payable to the new trustee or custodian. You would then deposit the check in your IRA rollover account.
Whatever you do, try to avoid having the trustee at your old 401(k) send a check made out only to you. If that happens, you won't owe tax on your money as long as you get it into the IRA within 60 days.
But because of a little twist that Congress slipped into the law 10 years ago, your old 401(k) would be required to withhold 20 percent of your 401(k) balance for taxes. You'll get that 20 percent back when you file your taxes, but in the meantime you'll have to come up with that amount to complete the rollover. If you can't, the IRS will consider that amount a distribution on which you would owe taxes and, possibly, that 10 percent tax penalty I mentioned earlier.
Have a look at the big picture
I also recommend that you use the rollover process as an opportunity to review your investing goals and then to build a diversified portfolio that meets your needs and risk tolerance.
In other words, don't just dump your rollover stash into whatever investment seems to be doing the best at the moment (not that there's a wide spectrum of those, these days). A quick visit to our Asset Allocation tool can help you create a portfolio that makes sense for your needs.
By the way, if your employer decides to launch a retirement savings plan -- or if you move to another job that offers such a plan -- you may be able to move your IRA rollover stash to that new plan (again, assuming you think the investing options are acceptable).
Indeed, the tax bill that president Bush signed into law back in 2001 (The Economic Growth and Tax Relief Reconciliation Act of 2001, as it's affectionately known in legislative circles), makes it possible to transfer money between different types of retirement plans, although the specific employer plan has to allow for such transfers.
One final note: since you're not covered by a plan at your new job, you want to look for other ways to continue saving for retirement, preferably in a tax-advantaged way. With no plan at work, you're probably eligible to contribute to either a traditional deductible IRA or a Roth IRA.
You could face restrictions if your wife is covered by a plan. In any case, you can check out your eligibility, and get advice on a regular vs. Roth, by clicking here.
The maximum you can contribute to a regular or Roth IRA is $3,000 this year, although that amount is scheduled to rise to $4,000 in 2005 and to $5,000 in 2008. People 50 or older can also kick in "catch up" contributions of up to $500 this year and up to $1,000 starting in 2006.
I recommend socking away every cent that you can and, again assuming you meet the eligibility rules, continue funding your regular IRA or Roth even if you again start participating in a 401(k). Come retirement, you'll be glad you did.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."