A statistic quoted in a recent Kiplingers Letter:
About 45% of folks who get a lump sum from an employer-sponsored retirement plan after changing jobs roll the entire sum into another tax-advantaged savings plan. That’s double the share who did so in the early 1990s, when lump sum distributions often prompted job changers to splurge on a new car or make another costly purchase.
Of course, this is an improvement but it’s still a very disturbing number, since it means that the majority – 55% – of folks who leave an employer and take their employer-sponsored retirement savings with them are taking that money out of tax-advantaged retirement plans. They may well just be paying the taxes (and, usually, penalties as well) and then investing the money. But chances are that they are not doing so, since if they were planning on investing the money anyway, they’d almost certainly not want to pay taxes and penalties.
It is possible that there’s a tax-rate arbitrage. If, for example, the person is unemployed for an extended period of time, it’s possible that their tax rate right now is much lower than their tax rate was when they were working and lower than they expect it to be when they start working again, so they are effectively converting pre-tax assets into post-tax assets at a lower than normal-for-them tax rate. But if they are under 59-1/2 years old, they are going to be paying an additional penalty which makes that conversion much more expensive than it may need to be. And additionally, if they really wanted to do just the tax-rate arbitrage, it’s possible that a Roth conversion would have made a lot more sense. So it’s simply highly unlikely that the money was taken out of a tax-advantaged retirement plan with any such intent.
Naturally, if the reason they are liquidating the assets is because they’ve left their employer and no longer are earning enough to live on, they may be doing so because they have no other choice. But that, too, is not likely in the majority of cases.
So what should they all be doing? Most of the time, when leaving an employer where one had a 401k or other similar tax-advantaged retirement plan, there are three options (aside from liquidating, paying taxes and penalties): (1) leave it there; (2) roll it into an IRA; or (3) roll it into a new employer’s plan.
There are advantages and disadvantages to all of these options. But for most folks, any one of those is a better idea than what that 55% of folks are doing – pulling the money out and paying taxes and penalties.