Does Your 401(k) Follow You When You Change Jobs?

A 401(k) plan is a tax-advantaged retirement savings vehicle, typically sponsored by an employer. Employees contribute a portion of their pre-tax salary, which can grow over time, often with employer contributions. A common question for individuals changing jobs is: what happens to their accumulated 401(k) funds?

Maintaining Your 401(k) with a Former Employer

Individuals separating from their employer can leave their 401(k) assets within the former employer’s plan. Funds continue growing under the existing investment options. Many plans permit this, especially if the account balance meets a threshold, often $5,000. However, some plans may automatically roll over smaller balances, typically under $1,000, into an Individual Retirement Account (IRA) if the participant does not provide other instructions.

When funds remain with a former employer, the participant can no longer make new contributions to that specific 401(k) account. The investment choices are limited to those offered by the former employer’s plan, and there may be administrative fees associated with maintaining the account. The former employer’s plan administrator remains the primary contact for any account-related inquiries or transactions.

Rolling Over Your 401(k)

Rolling over a 401(k) is a common method to maintain retirement savings in a tax-deferred or tax-free environment after changing jobs. This involves transferring funds from a former employer’s 401(k) to another qualified retirement account. There are two primary methods for executing a rollover: a direct rollover and an indirect rollover. A direct rollover occurs when the funds are transferred directly from the old 401(k) plan administrator to the new retirement account custodian, bypassing the participant entirely. This method avoids any tax withholding and is generally the most straightforward way to move funds.

In contrast, an indirect rollover involves the plan administrator issuing a check for the 401(k) balance directly to the participant. The participant then has 60 days from the date of receipt to deposit the full amount into a new qualified retirement account. If the funds are not deposited within this 60-day window, the distribution becomes taxable as ordinary income, and if the individual is under age 59½, it may also incur an additional 10% early withdrawal penalty. Furthermore, the IRS mandates a 20% federal income tax withholding on eligible rollover distributions that are paid directly to the participant, even if the intention is to complete an indirect rollover. This means the participant must use other funds to make up the 20% difference to deposit the full amount into the new account, and then reclaim the withheld amount when filing their tax return.

Funds from a former 401(k) can be rolled over into a new employer’s 401(k) plan, provided the new plan accepts inbound rollovers from other qualified plans. This option centralizes retirement savings with the current employer, potentially simplifying management. Another common destination for a 401(k) rollover is an Individual Retirement Account (IRA). Rolling over pre-tax 401(k) funds into a Traditional IRA allows the assets to continue growing on a tax-deferred basis, maintaining their tax-advantaged status. The process for initiating a rollover typically involves contacting the administrator of the former 401(k) plan and the custodian of the new retirement account to complete the necessary paperwork.

Alternatively, individuals can choose to convert their pre-tax 401(k) funds into a Roth IRA, a process known as a Roth conversion. While this move offers the benefit of tax-free withdrawals in retirement, the converted amount is immediately subject to ordinary income tax in the year of the conversion. Consequently, a Roth conversion may be more suitable for those who anticipate being in a higher tax bracket in retirement or who have other funds available to cover the immediate tax liability.

Cashing Out Your 401(k)

Choosing to cash out a 401(k) involves taking a lump-sum distribution of the account balance directly. While this option provides immediate access to the funds, it typically incurs significant financial consequences. The entire distributed amount is generally subject to ordinary income tax, added to the individual’s taxable income for the year of withdrawal. This can potentially push the individual into a higher tax bracket, leading to a larger overall tax bill.

In addition to income tax, individuals who are under the age of 59½ at the time of withdrawal will generally face an additional 10% early withdrawal penalty imposed by the Internal Revenue Service (IRS). However, certain exceptions to this 10% penalty exist. For instance, if an individual separates from service with their employer in or after the year they turn age 55, they may be able to withdraw funds from that employer’s 401(k) without incurring the 10% penalty, under what is known as the “Rule of 55.” Other exceptions include withdrawals due to total and permanent disability, unreimbursed medical expenses exceeding a certain percentage of adjusted gross income, or qualified higher education expenses.

When cashing out a 401(k), the plan administrator is generally required to withhold 20% of the distribution for federal income taxes. This mandatory withholding applies even if the individual plans to use the funds for an allowable exception or intends to complete an indirect rollover within the 60-day window. While the 20% is a withholding, not necessarily the final tax liability, it reduces the immediate cash received and must be reconciled when filing tax returns.

Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that must be taken from most tax-deferred retirement accounts, including 401(k)s and Traditional IRAs. These distributions ensure that individuals begin paying taxes on their deferred savings once they reach a certain age. For individuals who turn age 73 after December 31, 2022, RMDs generally commence at age 73. For those who turn age 64 after December 31, 2032, RMDs will begin at age 75.

The amount of the RMD is calculated annually based on the account balance at the end of the previous year and the individual’s life expectancy, as determined by IRS life expectancy tables. Financial institutions typically assist in calculating this amount. Failure to take the full RMD by the deadline can result in a substantial penalty. The penalty for not taking an RMD is generally 25% of the undistributed amount. This penalty can be reduced to 10% if the RMD is taken within a specific correction period and a reasonable explanation is provided to the IRS.

It is important to note that Roth IRAs do not have RMD requirements for the original owner during their lifetime. This distinction makes Roth IRAs a flexible option for estate planning, as funds can continue to grow tax-free and be passed to beneficiaries without the immediate need for withdrawals. However, inherited Roth IRAs are subject to RMD rules for beneficiaries.