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Cash out, roll over or leave 401(k) behind

Your job is gone, your bank account is dwindling, and that pot of money sitting in your retirement account at your former employer is looking mighty tempting. But the financial penalties you'll likely incur for cashing it out make that a bad idea under almost any circumstances. You're better off either doing an IRA rollover or letting the money stay put.

Option No. 1: Cashing out

First let's look at why the grab-and-go option is the worst of the three.

By cashing out, you not only get taxed and penalized, but you also lose the earnings that money could have generated. You won't even get all of your money: The employer is required to withhold 20 percent for the IRS. If you don't put the money in a qualified retirement account within 60 days, it's taxed as ordinary income. Add on a state income tax, if one applies to you. And if you are under age 59½, you'll incur a 10 percent early withdrawal penalty to boot.

Check out Bankrate's 401(k) spend it or save it calculator to see how much damage you can inflict on your future savings by cashing out your 401(k) early.

Option No. 2: Leaving the funds behind

To leave it with your former employer, your retirement account must contain a minimum amount, depending on what type of plan you have, and you will not be able to contribute additional money to the account.

Also, if you leave the funds in your 401(k) plan, you may be less likely to keep up with it after you're severed from the company.

"(Former employees) tend to move on," says Charlotte Dougherty, a Certified Financial Planner in Cincinnati, Ohio. "They tend to not pay attention to how their plan assets are invested, and they lose control of that bucket of money."

In some cases, though, leaving the money where it is might make sense, says Daniel Galli, a Certified Financial Planner in Norwell, Mass.

"If there is no need to access the money, the first step somebody should do is to take a look at the employer plan," Galli says.

A large employer may have a plan that, because of the size of its assets, has access to low-cost "institutional" funds that may not be available to individual investors. "They could buy a fund of the same name (in an IRA, for example), but it will have a higher expense ratio," Galli says.

While Galli sees several potential advantages to this option, Patrick Astre maintains there's usually only one good reason to leave your retirement funds behind when you separate from your job. If your 401(k) allows you to borrow from it, letting it stay in place can provide you with a backup when your cash starts running low. Unlike a cash out, the distribution for a loan is not taxed, as long as you repay the money. "But not all plans have that (option)," says Astre, a Certified Financial Planner in Shoreham, New York.

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