Take back your old 401(k)s

NEW YORK (Money) -- Question: I lost my job, so I have my retirement savings in three separate 401(k) accounts with three different employers. Should I just leave them there, roll them over into an IRA account or do something else? --Annie, Texas

Answer: If by "something else" you mean just cashing out one or more of your accounts, let's take that option off the table from the get-go.

I can understand that liquidating a 401(k) can be tempting for many people, especially if money is tight in the wake of a job loss. A recent survey by consulting firm Hewitt Associates shows that, layoff or no, nearly half of people with 401(k)s who leave their job take the money and run.

But that's typically not a very good choice. Aside from the fact that such a move will trigger income taxes and possibly a 10% penalty, taking the cash now could seriously jeopardize your retirement security. If you've still got a ways to go before retirement, raiding your savings early means you'll have a much smaller nest egg when you eventually retire. And if you're close to your retirement date, cashing out makes it less likely your savings will last as long as you do.

So unless you have no other way of getting by, I think we're really talking about either leaving your 401(k)s where they are or rolling them into an IRA. (It's also possible to roll your 401(k)s directly into a Roth IRA or roll them into an IRA and then move a portion into a Roth IRA. Remember, though, you'll have to pay income tax on the taxable portion of the amount you move to a Roth.)

With a couple of exceptions that I'll get to in a minute, I'm not a big fan of keeping money in the 401(k) plan of a company where you no longer work, assuming that's an option.

The main reason is that it raises the possibility -- a reality in your case -- that after a few job switches you could end up with your retirement savings divvied up among two, three or even more 401(k) plans at once. If your money is spread across a dozen or more different investment options in several different plans, it's all the harder to build a properly diversified portfolio and follow a coherent investing strategy. In this challenging market, the last thing you need is to make it even tougher to manage your dough.

I suppose you could make an argument for keeping your money in an old employer's plan if you felt the investment options were just so spectacular that you would be putting yourself at a big disadvantage by moving on. But, frankly, I doubt that's going to be a legitimate reason very often.

Fact is, if you roll over your 401(k) stash into an IRA, you've got thousands of mutual funds and other investments to choose from. Granted, many of these alternatives are subpar, but there are also plenty of good ones. Witness the low-cost index funds and reasonably priced actively managed funds on our Money 70 list of recommended funds. Without a whole lot of effort I think you can likely find investing choices that are as good as those in your 401(k), if not better.

There are some situations, however, when you may want to consider leaving your money in an old 401(k) plan at least temporarily.

One is if you think you'll move to another job with a 401(k) plan within a relatively short time. In such a case, it may be more convenient just to wait until you start your new job and transfer your old 401(k) to the new one rather than moving it to an IRA and then rolling the IRA into your new employer's plan. This assumes that your plan accepts rollover money and that the new 401(k) has reasonable fees and investing options.

Another scenario where it may pay to stay applies to people who are closer to retirement age. Let's say you leave your job and roll your 401(k) balance into an IRA account. And let's further assume that you need to tap into that money for living expenses. If you're under age 59 1/2, you'll not only owe income tax on the taxable portion of the amount you withdraw from the IRA, you'll also have to pay a 10% penalty, unless you qualify for one of the exceptions to the 10% surcharge.

But that 10% penalty doesn't apply to withdrawals from your company's 401(k) plan after you leave the company, provided you're 55 or older the year you stop working for that employer. So if you're at least 55 but under 59 1/2 and you think you might have to tap the money in your 401(k) within the next few years, you may want to leave your stash in your most recent employer's 401(k) until you turn 59 1/2. You'll still have to pay income tax on the taxable portion of any withdrawal, but at least you'll avoid the 10% penalty.

Barring such circumstances, however, I think it usually makes sense to roll your old 401(k) balance into an IRA. Even then, you want to think carefully about how you do it.

It's usually best if your former employer does a direct, or trustee-to-trustee, transfer to the IRA. If the plan instead pays the 401(k) balance directly to you, you could face the hassle of dealing with a 20% withholding tax.

That said, if you own lots of company stock in your 401(k) that has appreciated substantially it may not make sense to roll your entire balance into an IRA. Rather, you may want have the plan distribute the company shares to you and then roll over the remaining balance to an IRA. That way you can capitalize on the NUA, or net unrealized appreciation, in the company stock. Be careful, though. Although this tactic can sometimes provide big tax savings, it can also be tricky to pull off. And it has potential drawbacks even when done correctly.

So unless you're in one of the special situations I mentioned, I suggest you contact the 401(k) administrators for your various former employers and get them to transfer your balances to an IRA. Once you've got your far-flung accounts in one place, you'll have a much better shot at parlaying those balances, plus any savings you add in the future, into a lifetime of financial security.