What Are Your Termination Distribution Options?

When you leave an employer, you must decide what to do with the funds in your workplace retirement account, like a 401(k) or 403(b). This is known as a termination distribution. The options are governed by federal regulations and your former employer’s plan rules, and your choice has lasting implications for your retirement savings and current tax situation.

Available Distribution Options

Leave the Funds in the Former Employer’s Plan

You can leave your savings in your former employer’s retirement plan if your vested account balance is over $7,000, as plans can force out balances below this amount. This may provide access to low-cost institutional investment funds not available to individual investors. However, you will remain subject to the plan’s rules and investment limits and must maintain a financial relationship with a former employer, which can complicate managing your finances.

Roll Over to a New Employer’s Plan

If your new employer offers a compatible retirement plan, you may be able to move your old account balance into it. This process, known as a rollover, consolidates your retirement assets into a single plan, simplifying account management. You must first confirm that the new employer’s plan accepts rollovers. Once moved, your funds will be subject to the investment choices and rules of the new plan.

Roll Over to an Individual Retirement Account (IRA)

You can roll the funds from your former employer’s plan into an Individual Retirement Account (IRA), which is a personal retirement account you control. This option provides the widest array of investment choices, allowing you to tailor your portfolio to your financial goals. A rollover to an IRA maintains the tax-deferred status of your savings, so no taxes are due at the time of the transfer, giving you more control than an employer-sponsored plan.

Take a Lump-Sum Cash Distribution

You can take your entire vested account balance as a cash payment, known as a lump-sum distribution. This gives you immediate access to your funds for any purpose, but it has major financial repercussions. Cashing out triggers tax consequences and potential penalties, detailed below. This action removes the money from its tax-advantaged status, halting its potential for future tax-deferred growth and impacting your long-term retirement security.

Tax Consequences of Your Choice

Taxation of a Lump-Sum Distribution

A lump-sum cash distribution has immediate tax implications. Your plan administrator must withhold a mandatory 20% of the taxable portion for federal income taxes. For example, on a $50,000 distribution, $10,000 is sent to the IRS, and you receive $40,000.

This 20% is a prepayment, as the entire distribution is considered ordinary income and taxed at your marginal tax rate. If you are under age 59½, you will also face an additional 10% early withdrawal penalty on the full amount. Exceptions to the 10% penalty exist, including the “Rule of 55,” which allows penalty-free withdrawals if you leave your employer during or after the year you turn 55. Other exceptions include total and permanent disability, certain medical expenses, and distributions under a Qualified Domestic Relations Order (QDRO).

Taxation of Rollovers

A direct rollover, where funds are transferred from your old plan directly to a new plan or IRA, is a non-taxable event. No taxes are withheld, and the entire balance moves seamlessly, preserving its tax-deferred status. This is the most straightforward method for moving retirement funds.

An indirect rollover, where you receive a check made out to you, is more complex. You have 60 days from receiving the funds to deposit them into another retirement account. With an indirect rollover, the mandatory 20% federal tax withholding still applies. To complete a tax-free rollover, you must deposit the entire original distribution amount.

For example, on a $50,000 distribution, your old plan sends you $40,000 and withholds $10,000 for taxes. You must deposit the full $50,000 into a new account within 60 days, meaning you must contribute the $10,000 difference from other funds. If you only deposit the $40,000, the withheld $10,000 is considered a taxable distribution and may incur the 10% early withdrawal penalty.

Special Plan Provisions and Assets

Handling Outstanding Plan Loans

If you have an outstanding 401(k) loan when you leave your employer, it usually becomes due. Most plans require full repayment shortly after termination. If you cannot repay the loan, the balance is treated as a “loan offset,” which is a taxable distribution.

You have an extended period to avoid the tax consequences of a loan offset. You can roll over the outstanding loan amount to another retirement plan or an IRA until the due date of your federal income tax return for that year, including extensions. Failing to do so will result in the amount being taxed as ordinary income and possibly facing the 10% early withdrawal penalty.

Distributions from Roth 401(k) Accounts

Distributions from a Roth 401(k) are tax-free if they are “qualified.” A qualified distribution requires that you have held the Roth account for at least five years and are over age 59½, disabled, or the distribution is to a beneficiary after your death. The five-year clock for a Roth 401(k) starts on January 1 of the year of your first contribution.

When you roll over a Roth 401(k) to a Roth IRA, the holding period does not carry over. The five-year clock for qualified distributions from the Roth IRA is based on when you first funded any Roth IRA. If the rollover is your first contribution to a Roth IRA, a new five-year period begins.

Net Unrealized Appreciation (NUA) for Company Stock

The Net Unrealized Appreciation (NUA) rule applies to distributions of your former employer’s stock held in your retirement plan. NUA is the difference between the stock’s original cost basis and its current market value. This strategy can offer a tax advantage for highly appreciated company stock.

To use the NUA rule, you must take a lump-sum distribution of your entire account balance in a single tax year. The company stock is distributed to a taxable brokerage account, while other assets can be rolled over to an IRA. At the time of distribution, you pay ordinary income tax only on the stock’s original cost basis. The NUA portion is not taxed until you sell the shares, at which point it is taxed at long-term capital gains rates.

Initiating Your Distribution Request

Contacting the Plan Administrator

To initiate a distribution, contact the plan administrator. Their contact information is on your account statement, the plan’s website, or available from your former employer’s HR department. The administrator will guide you to the necessary forms and explain the procedures for your plan.

Completing the Required Paperwork

You must complete a distribution request package, either online or with paper forms, indicating your chosen option. For a direct rollover, you must provide the new plan or IRA’s account number and trustee information. For a cash distribution, you will supply your bank account details for direct deposit or a mailing address for a check. Some plans may also require spousal consent for certain distributions, which requires a separate notarized form.

Submission and Post-Submission Expectations

Submit the completed forms to the plan administrator via their specified method, such as an online portal, mail, or fax. You should receive a confirmation that your request is being processed, which takes about 7 to 14 business days. Your former employer must approve the distribution to verify your eligibility and loan status.

After approval, funds are transferred for a rollover or a check is mailed for a lump-sum payment. You will receive a Form 1099-R from the plan administrator in January of the following year, reporting the distribution to you and the IRS.