Initiate a direct rollover to the new account. Ask your former employer to directly transfer your 401(k) balance to an IRA or your new company's 401(k) plan. This is the simplest way to avoid taxes and penalties when closing out an old 401(k) plan. "If you are planning to leave the money tax-deferred, then the best way to do that is a trustee-to-trustee transfer," says Rosemary Danielson, a certified financial planner for Balanced Financial Planning in Overland Park, Kan. "A trustee-to-trustee transfer allows you to avoid having any tax withheld on that rollover."
If you instead get a personal check from your employer, 20 percent of your account balance will be withheld for income tax. And if you don't deposit the entire account balance, including the withheld 20 percent, into a new retirement account within 60 days, it is considered a withdrawal. You will become responsible for paying income tax and, if under age 55, a 10 percent early withdrawal penalty on any amount not rolled over. For example, if you have $100,000 in your 401(k), your employer could write you a check for $80,000. If you only deposit the $80,000 in an IRA, the $20,000 will be counted as income and taxes and the early withdrawal penalty may be applied.