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Avoiding taxes when leaving an employer's retirement plan

| MoneyRates.com Senior Financial Analyst, CFA
min read

Taxes on retirement income and earnings are generally deferred until you start drawing money out in retirement -- but what happens to retirement plan money if you simply change jobs?

Worst-case scenario: In addition to the ordinary income taxes due on money you receive from your former employer's retirement plan, you could be required to pay a 10 percent penalty if you're under 59 1/2.

However, if you play your cards right, you can avoid this penalty altogether and defer taxes until retirement.

The key is to make a rollover to another qualified retirement plan within the 60-day window allowed by the IRS. The following are some specifics on what this might entail for a pension or a 401(k) withdrawal.

Avoiding taxes on pension plan distributions

A pension is a retirement plan that promises to pay you specific benefits based on your earnings and length of service with an organization.

Are you vested?
The first thing to determine is whether or not your benefits are vested. Often, eligibility for benefits depends on serving with the organization for minimum time period and, if you leave before that time, some or all of your benefits will be forfeited.

If you are vested…

    1. Can you leave your money in the pension plan when you change jobs?
      If you are entitled to vested pension benefits, you will probably have two choices. In some cases, you can choose to leave your money in the pension plan and receive your benefits as scheduled upon retirement. In that case, there should be no issues with taxation until you start receiving those benefits.

    2. Do you have to leave the plan when you change jobs?Often, a pension will require you to:

      • leave the plan when you leave the sponsoring employer,

      • and accept a lump-sum payment in lieu of retirement benefits.
        (This lump-sum payment must be handled correctly to avoid incurring immediate taxes and penalties.)

        You can continue to defer taxes if you roll that money into a qualified retirement vehicle, such as an employer-sponsored retirement plan or a traditional IRA, within 60 days. It is generally most efficient if you can get the money transferred directly from the pension plan into another qualified plan rather than receiving the money personally and then depositing it in the new plan later.

Cashing out a 401(k) after leaving a job

When it comes to cashing out a 401(k) after leaving a job, what you are entitled to is based on the current market value of your 401(k) balance.

In some rare cases, you might be able to leave that balance in the 401(k) plan after you change jobs, at least for a period of time. Most often, though, you will have to take that balance with you when you leave. This 401(k) withdrawal could subject you to taxes and the 10 percent penalty if it is not handled correctly.

To avoid taxes and the early withdrawal penalty, you must roll your 401(k) balance into another qualified plan within 60 days. You may be able to roll that money into a 401(k) plan at a new employer; but if that is not available, you can roll it into a traditional IRA instead. Here again, it is best to arrange for a direct rollover from the old plan if possible.

Plan ahead to smooth the way

Because there is a limited amount of time involved -- and possibly a significant amount of money at stake -- if possible, plan ahead about how to handle your pension or 401(k) withdrawals before leaving an employer.

          1. Can you remain in the plan?
            Find out if there are any provisions for remaining within the plan, or what the grace period is (if any) before you have to take your money out. If you have a new employer lined up and they have a retirement plan, talk to their benefits office about whether that plan can accept rollovers.

          2. Do you have to withdraw your funds?
            If you cannot simply roll money from your previous employer's plan into a new employer's plan, you can still avoid taxes by setting up an IRA rollover. Just remember, though -- the 60-day clock is ticking, so don't delay!
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