Should I Move My 401k to a New Employer?

When transitioning to a new employer, a common financial consideration is what to do with the 401(k) plan from the previous job. Understanding these choices is important for making an informed decision about managing retirement savings. This article outlines the available paths, evaluates key factors for each, details the process of initiating a rollover, and highlights the considerations involved in taking a cash distribution.

Available Paths for Your Former Employer’s 401(k)

Upon leaving a job, individuals typically have four primary options for their former employer’s 401(k) plan.

• Leave the funds within the former employer’s plan, provided the plan administrator allows it. The account remains with the previous plan provider.
• Roll over the funds into a new employer’s 401(k) plan. This option consolidates retirement savings into the current workplace plan.
• Roll over the funds into an Individual Retirement Account (IRA), which is a retirement savings plan established by the individual with a financial institution. This provides broader control over investment selection.
• Take a cash distribution, also known as cashing out the funds. This involves receiving the account balance directly as a taxable payment.

Evaluating Each Path: Key Factors

Deciding the future of a former employer’s 401(k) involves assessing several factors across the available options.

Fees and Costs

Fees and costs represent a significant consideration, as they can vary considerably between former employer 401(k)s, new employer 401(k)s, and IRAs. For instance, 401(k) fees can range from 0.2% to 5% of assets, encompassing administrative and investment fees. IRA fees often include annual maintenance fees, which ideally should be below 1% annually, with many brokerages waiving fees entirely. Investment management fees for IRAs can range from 0.80% to 1.20% for human advisors, or 0.20% to 0.45% for robo-advisors.

Investment Options

Employer-sponsored 401(k)s typically offer a curated selection of mutual funds, often including target-date funds, which adjust asset allocation based on a projected retirement year. While some 401(k)s may have limited choices, IRAs generally provide a much broader range of investment vehicles, such as individual stocks, exchange-traded funds (ETFs), and a wider variety of mutual funds, offering greater flexibility for portfolio construction.

Access to Funds

Access to funds is another important aspect, particularly regarding withdrawals and loans. Generally, withdrawals from 401(k)s and IRAs before age 59½ may incur a 10% early withdrawal penalty, in addition to being taxed as ordinary income. However, a notable exception for 401(k)s is the “Rule of 55,” which allows penalty-free withdrawals from the plan of the employer from whom an individual separated service in the year they turn 55 or later. This rule does not apply to IRAs. While 401(k) plans may permit loans, IRAs typically do not.

Creditor Protection

Creditor protection varies significantly. Funds held in employer-sponsored 401(k) plans are generally protected from creditors under the Employee Retirement Income Security Act (ERISA), a federal law that provides a strong shield against most claims, including bankruptcy. This protection often extends to the entire plan assets. For IRAs, federal protection in bankruptcy is provided by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which protects traditional and Roth IRAs up to a specific inflation-adjusted limit. Rollover IRAs originating from an ERISA-qualified plan may retain unlimited protection in bankruptcy, but outside of bankruptcy, IRA creditor protection often depends on state law.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are another factor to consider. Generally, individuals must begin taking RMDs from traditional IRAs and most 401(k) plans at age 73. However, participants in a workplace retirement plan (like a 401(k)) can sometimes delay RMDs until they retire, unless they own more than 5% of the business. Roth IRAs, on the other hand, are not subject to RMDs during the original owner’s lifetime.

Administrative Burden

The administrative burden associated with each option can also influence a decision. Leaving funds in a former employer’s 401(k) or moving them to a new employer’s plan typically involves minimal personal management, as the plan administrator handles most aspects. Conversely, managing an IRA, especially a self-directed one, places more responsibility on the individual for investment selection and oversight.

Tax Considerations

Finally, tax considerations are central to the evaluation. Contributions to traditional 401(k)s and traditional IRAs are typically made pre-tax, meaning taxes are deferred until withdrawal in retirement. Roth 401(k)s and Roth IRAs are funded with after-tax dollars, leading to tax-free qualified withdrawals in retirement. The tax treatment of growth and distributions within these accounts should be understood.

Initiating a Rollover

Once the decision is made to roll over funds from a former employer’s 401(k), understanding the procedural steps is essential.

Direct Rollover

The most common and generally recommended method is a direct rollover. In this process, the funds are transferred directly from the former employer’s plan administrator to the new employer’s 401(k) plan or an IRA custodian. This direct transfer ensures that the individual never takes physical possession of the funds, thus avoiding potential tax complications and mandatory withholding. To initiate a direct rollover, individuals typically need to contact their former employer’s plan administrator and request the transfer. They will need to provide the new account details, including the name of the receiving institution and the new account number.

Indirect Rollover

An alternative, less common method is an indirect rollover. With this approach, the funds are first distributed to the individual, usually by check. The individual then has a strict 60-day period from the date of receipt to deposit the entire amount into a new qualified retirement account, such as a new 401(k) or an IRA. A significant aspect of an indirect rollover from a 401(k) is the mandatory 20% federal income tax withholding that typically applies to the distribution. This means the individual will receive only 80% of the funds. To complete the rollover and avoid taxes and penalties on the full amount, the individual must deposit the entire original distribution, including the 20% that was withheld, within the 60-day timeframe. If the full amount is not deposited, the unrolled portion is considered a taxable distribution and may be subject to early withdrawal penalties if the individual is under age 59½.

Required Information and Processing

For either rollover type, certain information and documentation are required. This includes personal identification, account numbers for both the old and new plans, and potentially specific forms from both the former plan administrator and the new custodian. These forms facilitate the transfer and ensure proper reporting to the Internal Revenue Service (IRS). Processing times for rollovers can vary, often taking several weeks, so follow-up with both institutions is advisable to confirm the successful completion of the transfer.

Considerations for Taking a Cash Distribution

Taking a cash distribution from a former employer’s 401(k) involves significant financial and tax implications.

When funds from a pre-tax 401(k) are cashed out, the entire amount is typically treated as ordinary income in the year it is received. This means the distribution is added to the individual’s other income for the year and taxed at their applicable federal income tax rate.

In addition to income tax, individuals under age 59½ usually face a 10% early withdrawal penalty on the distributed amount. While some limited exceptions to this penalty exist, such as for disability or certain unreimbursed medical expenses, they are generally specific and do not apply to most situations.

A cash distribution also results in the immediate loss of the long-term tax-deferred growth potential that the retirement savings would have otherwise accumulated. This can significantly diminish an individual’s total retirement nest egg over time. Furthermore, a mandatory 20% federal income tax withholding is generally applied to eligible rollover distributions that are not directly rolled over, meaning the individual receives only 80% of the account balance initially. This withholding does not exempt the individual from any additional taxes or penalties owed, and the full amount is still considered taxable income.