by Archie M. Richards, Jr., CFP^®
January 23, 2005

When changing jobs, you should probably transfer the money in your former employer's 401(k) plan to an IRA.

Here are the possibilities:

A popular choice -- asking for cash - is the wrong choice. Piling on top of your employment income, the withdrawal probably throws you into a higher tax bracket. Having a big chunk of cash on hand also tempts you to blow the money.

Some people ask for cash, intending to roll it over to an IRA. But the rollover must occur within 60 days - no exceptions. After changing jobs, you're busy moving your family and getting your life in order. It's easy to forget about the 60-day limit. Whoops, the entire amount becomes taxable. Besides, the former employer can't even send you the entire balance of your 401(k) plan. Only 80 percent goes to you; 20 percent goes to the IRS. In your tax return for that year, you can reclaim the 20-percent share. But in the meantime, you're required to roll over 100 percent of the 401(k) balance to the IRA. To come up with the 20-percent difference, you have to dip into other funds. If you don't have this kind of scratch, you'll have to pay tax and maybe a penalty on the shortfall. Drop the 60-day rollover idea.

You can request a non-taxable transfer from the 401(k) plan of your former employer to that of your new employer. This is the right approach if you're subject to lawsuit. A physician likely to be sued for malpractice, for example, is better off with a 401(k) than with a personal IRA. 401(k)s provide better protection against the claims of creditors.

If your new employer matches your contributions, by all means take advantage of the company's 401(k) plan. But the 401(k) of your former employer should probably be transferred an IRA. Except for matching, here's why 401(k)s should usually be avoided:

• They're expensive - much more so than the Vanguard or Foliofn IRA accounts this column has suggested. Most 401(k) plans have operating costs of 1.5 percent just for the plan, never mind sales charges and high operating costs of the investments themselves. Over the years, high costs make a huge difference in long-term results.

• Some people transfer to the new employer's 401(k) because it's more difficult to withdraw from a 401(k) than from an IRA. Money harder to withdraw is less likely to be spent. But you're better off cutting your expenses. Get this down pat, so you may adopt an IRA and have no fear of spending retirement money prematurely.

• Some people like the limited investment choices available in 401(k) plans, rather than the unlimited choices one faces in an IRA. But in www.archierichards.com, click on Suggested Portfolio. You'll find a limited number of investment choices that'll fill the bill nicely for an IRA.

• Still others want to borrow from a 401(k), which they can't do from an IRA. You may say to yourself, Borrowing from my 401(k) costs nothing, because I'm paying interest to myself. I beg to differ. Money borrowed is money not invested. The dividends and appreciation lost could eventually amount to hundreds of thousands of dollars forfeited.

• Unlike IRAs, 401(k) plans offer stable-value funds, which provide relatively high yield with no changes in principal value. But I would avoid stable-value funds if I were you. For a fulfilling retirement, you need a little higher risk and a lot higher long-term return. The aforementioned Suggested Portfolio points the way.

• If you die with funds remaining in your 401(k) and you've named beneficiaries other than your spouse, the beneficiaries must withdraw all the 401(k) money and pay heavy taxes shortly after your death. But with an IRA, the beneficiaries can withdraw the money over their lifetimes, paying tax only from year to year. A tax delayed is money saved.

After changing jobs, most people should request a non-taxable transfer of their former employer's 401(k) money to an IRA. Oh yes, and forget about dipping into your retirement funds to relieve financial stress. Cut your expenses instead.