Does Your 401(k) Transfer Between Jobs?

A 401(k) is an employer-sponsored retirement savings plan that allows individuals to contribute a portion of their paycheck, often with employer contributions, to save for retirement. These plans offer tax advantages, such as tax-deferred growth for traditional 401(k)s or tax-free withdrawals in retirement for Roth 401(k)s. As individuals frequently change jobs throughout their careers, a common question arises regarding what happens to these accumulated retirement savings. Understanding options for managing a 401(k) when changing jobs is important for long-term financial goals.

Available Choices for Your Old 401(k)

When leaving an employer, individuals typically have four main choices for managing their existing 401(k) funds. One option is to leave the funds in the former employer’s 401(k) plan. The money remains invested under the original plan’s rules and investment options. However, new contributions cannot be made to this account.

Another possibility involves rolling over the funds to a new employer’s 401(k) plan. This allows for consolidation into a single account, provided the new employer’s plan accepts rollovers. Consolidating accounts simplifies management.

Individuals can also choose to roll over their 401(k) into an Individual Retirement Account (IRA). This transfers funds to a personally managed IRA, which can be Traditional or Roth depending on tax situation. IRAs typically offer a broader range of investment choices compared to employer-sponsored plans.

The fourth option is to cash out the account, taking a lump-sum distribution. This results in immediate tax consequences, as the withdrawn amount is taxable income. Additionally, if the individual is under age 59½, a 10% early withdrawal penalty usually applies to the distributed amount.

Understanding the Rollover Process

When choosing to move 401(k) funds, the rollover process can be executed in two primary ways: direct or indirect. A direct rollover is the preferred and most common method, where the funds are transferred directly from the old plan administrator to the new plan administrator or IRA custodian. The money never passes through the individual’s hands, which ensures the transfer is generally tax-free and avoids potential withholding issues.

An indirect rollover, also known as a 60-day rollover, involves the funds being distributed directly to the individual. The individual then has 60 days from the date of receipt to deposit the full amount into another qualified retirement account, such as an IRA or a new employer’s 401(k). If the funds are not redeposited within this 60-day window, the entire amount becomes taxable income, and if the individual is under age 59½, a 10% early withdrawal penalty will apply.

A significant aspect of an indirect rollover is the mandatory 20% federal income tax withholding. The old plan administrator withholds 20% for federal taxes. To complete the rollover and avoid taxes and penalties, the individual must deposit the entire original distribution amount, including the 20% that was withheld, into the new retirement account within the 60-day period. This often means the individual needs to use other personal funds to make up for the withheld amount, which will then be recovered when filing their tax return.

To initiate any rollover, certain information and documentation are necessary. This typically includes the old 401(k) account number, contact details for both the former plan administrator and the new plan provider (or IRA custodian), and specific rollover request forms from the old plan. The new plan provider or IRA custodian can often assist in providing the necessary receiving institution details.

The procedural steps to complete a rollover typically begin by contacting the former employer’s 401(k) plan administrator to request a rollover. For a direct rollover, the old plan administrator electronically transfers the funds or issues a check made payable directly to the new plan or IRA custodian. For an indirect rollover, a check is issued to the individual, who is then responsible for depositing it into the new account within the 60-day timeframe. After the transfer, confirm with the new plan provider or IRA custodian that funds have been successfully received.

Important Considerations When Deciding

When evaluating options for an old 401(k), the range of investment choices and overall flexibility are important factors. IRAs generally offer the broadest selection of investment vehicles, including individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs), providing extensive control over portfolio construction. Employer-sponsored 401(k) plans, both old and new, typically have a more limited menu of investment options curated by the plan administrator, often consisting of a selection of mutual funds.

Fees and expenses associated with each option also warrant careful consideration. These include administrative and investment management fees. While 401(k) plans may have bundled fees that are less transparent, IRAs typically have clearer, unbundled fees. Comparing the expense ratios of available funds and any account maintenance fees across different options can help in making a cost-effective decision.

Creditor protection is another aspect to consider. Funds held in 401(k) plans generally receive strong federal protection from creditors under the Employee Retirement Income Security Act (ERISA). These assets are typically shielded from bankruptcy and other legal claims. While IRAs also receive some federal protection in bankruptcy, the extent of protection from other creditors can vary by state law.

Differences in withdrawal rules and age restrictions are also notable between plan types. For 401(k)s, if an individual separates from service at age 55 or older, they may be able to withdraw funds from that specific 401(k) without incurring the 10% early withdrawal penalty, a provision known as the “Rule of 55.” For IRAs, penalty-free withdrawals typically begin at age 59½. Both types of accounts are subject to ordinary income tax on withdrawals of pre-tax contributions and earnings.

The general tax implications should always be a primary consideration. Rollovers, whether direct or indirect (if completed within 60 days), are generally tax-free events, meaning the funds continue to grow on a tax-deferred basis without immediate taxation. Cashing out, however, results in the entire distribution being taxable income and can trigger the 10% early withdrawal penalty, reducing the amount available for retirement.