What happens to your 401k plan when you leave your employer?

My job will offer me a 401k plan after 3 months of working for them. Great! But I doubt I will work in the rigorous and demanding environment of big four public accounting for the rest of my life (or maybe I will, who knows?...but lets get pessimistic for a moment). Ok... so I will have put in a great deal of money into my firm's 401k, but then what happens if I decide to make a run for it to save my social life? What happens to my cushy dream of Tahiti and Mai Tai's at the ripe age of 80?

Answer: My savings can stay safe!

When you leave your employer, with whom you have your 401k you often have 4 choices:

1) Leave your money where it is
This is probably not the best solution because leaving it there restricts you from contributing further to the plan and you do not have access to it for a loan. In addition, many employers will charge administrative and other fees to manage your account after you have left, which can be costly.

2) Cash out
This is probably the worst decision you could make. Doing this is financial suicide, as you would not only be hit with the income tax on the lump distribution but you would be hit with the 10% penalty for early withdrawal as well. In some cases, this could leave you with a meager half the value of your plan.

3) Rollover your 401k into your new employer's plan
This is a good idea given your new plan allows it. A direct rollover (or "trustee-to-trustee" transfer) is the best option if it is available. That is, the check must not be made out to you. It should be made from the trustee of your old account to the custodian of your new account. It is the least cumbersome option and leaves no room for the IRS to consider it an early withdrawal.

Alternatively, you can have the check made out to you, as long as you deposit the check in your vehicle within 60 days (indirect rollover). This is not as favorable an option. With an indirect rollover your previous employer is required to withhold 20% for federal income taxes. You get a credit for this amount on your income tax return for the year, but you must come up with the 20% out-of-pocket to contribute into your new plan. Otherwise, that 20% is considered a taxable distribution and subject to the 10% early withdrawal penalty (Yikes!).

4) Rollover your 401k into an IRA.
This is your best option if you do not have a 401k plan with your new employer. Similar to rolling it into a new 401k, a direct rollover is the best option if available. If you hope to have a 401k plan in the future, I recommend opening a separate IRA (different from one you may already have open) and do not make any more contributions into this account. This way, you have the option to rollover this account into any 401k you may have with a future employer.

And there you have it! See, no need to fret. If correctly executed, your savings will be as safe as an SUV in a head on collision with a bicycle.