If You Leave a Job, Can You Cash Out Your 401k?

A 401(k) plan is an employer-sponsored retirement savings account designed to help individuals save for their future with certain tax advantages. These plans encourage long-term savings by offering tax-deferred growth on investments, meaning you typically do not pay taxes on contributions or earnings until retirement. When you leave a job, questions naturally arise about what happens to the funds accumulated in your 401(k). This article will explore the various options available for managing these funds after job separation.

Accessing 401(k) Funds

“Cashing out” a 401(k) refers to taking a direct distribution of the funds from the account. This action is generally termed an “early distribution” if it occurs before age 59½. Such distributions typically have two main financial consequences: they are subject to ordinary income tax and often incur an additional federal penalty.

The entire distributed amount is usually added to your taxable income for the year, and it will be subject to your marginal income tax rate. A 10% additional federal tax, commonly known as an early withdrawal penalty, usually applies to distributions taken before you reach age 59½. This penalty discourages using retirement funds for non-retirement purposes.

There are specific circumstances where the 10% early withdrawal penalty may be waived, although the distribution generally remains subject to ordinary income tax. One common exception for individuals separating from service involves the “Rule of 55.” If you leave your job in or after the calendar year you turn age 55, you can take penalty-free distributions from that specific employer’s 401(k) plan. For qualified public safety employees, this age threshold is age 50.

Other situations that may exempt distributions from the 10% penalty include distributions due to total and permanent disability, where a physician certifies your inability to engage in substantial gainful activity. Distributions that are part of a series of substantially equal periodic payments (SEPP) also avoid the penalty, provided they follow strict IRS rules for at least five years or until age 59½, whichever is later. Distributions for certain unreimbursed medical expenses exceeding 7.5% of your adjusted gross income may also qualify for a penalty waiver. Unless from a qualified Roth 401(k) account that has met specific conditions, the distributed amount is still considered taxable income.

Alternative Strategies for Your 401(k)

Beyond cashing out, several alternative strategies exist for managing your 401(k) funds after leaving a job. One common option is to roll over the funds into an Individual Retirement Account (IRA). This can be done as a direct rollover, where funds are transferred directly from your old 401(k) plan administrator to your new IRA custodian, or as an indirect rollover.

In a direct rollover, the money never passes through your hands, avoiding potential tax withholding. For an indirect rollover, you receive a check, and you must deposit the full amount into a new IRA within 60 days to avoid it being treated as a taxable distribution and potentially incurring the 10% early withdrawal penalty if you are under 59½. It is important to note that you are generally limited to one indirect rollover from an IRA to another IRA within any 12-month period. Rolling over to an IRA can offer continued tax-deferred growth, a broader selection of investment options, and the benefit of consolidating multiple retirement accounts. You can roll pre-tax 401(k) funds into a Traditional IRA, or if your 401(k) includes Roth contributions, those can be rolled into a Roth IRA tax-free.

Another strategy involves rolling your funds into a new employer’s 401(k) plan. This option is available if your new employer’s plan accepts incoming rollovers. Benefits include keeping your retirement savings consolidated and continuing tax-deferred growth. You may also maintain access to loan provisions that some 401(k) plans offer.

A third possibility is to leave your funds in your old employer’s 401(k) plan. This is typically an option if your account balance exceeds a certain threshold, often $5,000. Advantages include familiarity with the existing investments, and the significant creditor protection offered by the Employee Retirement Income Security Act (ERISA), which applies to most employer-sponsored plans. However, potential drawbacks include limited control over investment choices, the possibility of forgetting about the account over time, or the former employer’s plan potentially terminating or changing its terms.

Executing Your 401(k) Decision

Once you have determined the most suitable strategy for your 401(k) funds after leaving a job, the next step involves initiating the process with your former employer’s plan administrator. Begin by contacting your previous employer’s human resources department or directly reaching out to the 401(k) plan administrator. They will guide you through the specific procedures and provide the necessary forms for distribution or rollover.

The plan administrator will supply the required paperwork. These forms will detail your chosen option, whether it is a direct distribution, a rollover to an IRA, or a transfer to a new employer’s plan. Submitting these forms can usually be done through various methods, including mail, an online portal, or fax.

For any direct distribution that is eligible for rollover but is paid directly to you, federal law mandates a 20% federal income tax withholding. This withholding is a prepayment of taxes owed. If you intend to complete an indirect rollover, you will need to contribute funds from other sources to make up for this 20% withholding to roll over the entire original amount.

The time it takes for funds to be distributed or transferred can vary. Direct rollovers are generally faster. If you receive a check for an indirect rollover, the 60-day clock begins ticking on the date you receive the check, and you must deposit it into the new account within that timeframe.

After the transaction is processed, you should expect to receive confirmation statements from both the old and new plan administrators. For any distributions, you will also receive IRS Form 1099-R by January 31 of the year following the distribution. This form is essential for reporting the transaction on your tax return.