How to Close Out a 401(k): Rollovers and Withdrawals

A 401(k) plan is an employer-sponsored retirement savings account designed to help individuals save for their future. It allows a portion of each paycheck to be invested, often with potential tax advantages, depending on whether contributions are made on a pre-tax or after-tax basis. Many employers offer these plans as part of their benefits packages, and some may even contribute to employee accounts through matching programs.

Individuals consider closing out a 401(k) when they change jobs, retire, or seek to consolidate multiple retirement accounts from previous employers. Understanding the available options for managing these funds is important for sound financial planning. This process involves navigating specific rules and potential tax implications to ensure retirement savings continue to grow.

Understanding Your Options and Initial Information Gathering

When transitioning from an employer, individuals have several choices regarding their accumulated 401(k) funds. One option is to leave the funds within the former employer’s plan, which might be suitable if the plan offers low fees and a broad selection of investment choices. However, this approach means you can no longer contribute to the old plan or receive employer matches, and managing multiple accounts can become cumbersome.

Another common path involves moving the funds to a new retirement account, known as a rollover. This can include transferring the money to a 401(k) plan with a new employer or into an Individual Retirement Account (IRA). Rollovers allow your retirement savings to remain tax-deferred while potentially offering more control or investment flexibility.

A third option is to take a direct cash withdrawal from the 401(k) account. This provides immediate access to funds but often carries tax consequences and potential penalties. Before deciding, gather specific information from the former employer’s plan administrator. This includes the current account balance and the vested amount, which represents the portion of employer contributions that legally belongs to you.

Obtain the available distribution forms and instructions specific to your plan, along with contact information for the plan administrator. Understand any particular plan rules or limitations regarding distributions. For instance, some plans may require spousal consent for certain distributions or have specific procedures for initiating transfers.

Executing a Rollover

A rollover involves moving retirement savings from one qualified account to another, preserving their tax-deferred status. The most advantageous method is a direct rollover, where funds transfer directly from the old 401(k) plan to the new retirement account without passing through your hands. This process helps avoid mandatory tax withholding and potential early withdrawal penalties. To initiate a direct rollover, contact your former plan administrator and request the necessary forms, providing details of the receiving institution, such as the new 401(k) plan or IRA. The plan administrator then sends the funds directly to the new account.

Alternatively, an indirect rollover involves funds distributed directly to you, after which you have a 60-day period to deposit the money into a new retirement account. This method is less preferred because the plan administrator is required to withhold 20% of the distribution for federal income tax. To complete the rollover and avoid the distribution being considered taxable income, you must deposit the full amount of the original distribution, including the 20% withheld, into the new account within the 60-day timeframe. If you fail to deposit the full amount, the withheld portion becomes a taxable distribution subject to ordinary income tax and, if applicable, an early withdrawal penalty.

When considering where to roll over funds, individuals weigh transferring to a new employer’s 401(k) versus an IRA. Rolling into a new 401(k) can simplify management by keeping all retirement savings in one place, assuming the new plan accepts rollovers. However, an IRA offers a wider array of investment options and potentially lower fees compared to many employer-sponsored plans. Deciding between these options depends on factors such as investment choices, fee structures, and creditor protection offered by each account type.

Understanding and Managing Direct Withdrawals

Cashing out a 401(k) before retirement age carries financial implications, as the withdrawn amount is treated as ordinary income and is subject to the individual’s marginal income tax rate. Beyond income tax, withdrawals made before age 59½ incur an additional 10% early withdrawal penalty under Internal Revenue Code Section 72(t).

When a taxable distribution is paid directly to you, there is a mandatory 20% federal income tax withholding, even if you intend to roll over the funds later. This withholding applies to eligible rollover distributions not directly transferred to another qualified plan. If the distribution is not rolled over, the remaining portion is included in your taxable income for the year, and the 20% withheld is credited against your total tax liability.

Several exceptions to the 10% early withdrawal penalty exist. For instance, the penalty may be waived if the withdrawal occurs due to separation from service at or after age 55, or age 50 for public safety employees, but this applies only to the plan from the employer you just left. Other exceptions include distributions made due to a qualified disability, unreimbursed medical expenses, qualified higher education expenses, or for a first-time home purchase.

Additional penalty exceptions apply for distributions made as part of a series of substantially equal periodic payments (SEPPs) under Internal Revenue Code Section 72(t), or if the distribution is made to satisfy an IRS levy. New exceptions for emergency personal expense distributions and distributions to domestic abuse victims were introduced, starting in 2024. To request a direct withdrawal, contact your plan administrator, complete the necessary forms, and provide instructions for payment.