What Do You Do With a 401k When You Leave a Job?

When employment ends, individuals face decisions regarding their 401(k) retirement savings plan. A 401(k) is an employer-sponsored plan allowing eligible employees to save and invest for retirement on a tax-advantaged basis. The choices made about these funds have significant financial and tax implications, affecting long-term retirement security. Understanding the available options is crucial for informed decisions.

Options for Your Old 401(k)

Individuals have several choices for managing their 401(k) balance after leaving a job. One option is to leave the funds in the former employer’s plan, typically permissible if the account balance exceeds a certain threshold. No new contributions can be made, and investment options may be limited.

Another common choice involves rolling over the funds into a new employer’s 401(k) plan, if allowed. This consolidates retirement savings, simplifying management. However, the investment choices and fees of the new plan should be reviewed.

Rolling the funds over to an Individual Retirement Account (IRA) is a flexible option, providing access to a broader range of investment choices than many employer-sponsored plans. This can involve either a Traditional IRA or a Roth IRA, each with distinct tax treatments. Finally, individuals can choose to cash out their 401(k) by taking a lump-sum distribution, though this option usually carries significant tax consequences and penalties, making it not recommended.

Understanding Rollovers

A rollover involves transferring funds from one qualified retirement account to another without incurring immediate taxes or penalties. This process allows retirement savings to continue growing on a tax-deferred basis. There are two primary methods for executing a rollover: a direct rollover or an indirect rollover.

A direct rollover, also known as a trustee-to-trustee transfer, is the preferred and most straightforward method. Funds are transferred directly from the former 401(k) plan administrator to the new retirement account custodian without passing through the account holder’s hands. This method avoids mandatory tax withholding and eliminates the risk of missing a deadline. The account holder simply instructs the old plan administrator to send the funds to the new account.

An indirect rollover, also referred to as a 60-day rollover, is less common and involves more risk. The 401(k) plan administrator issues a check for the distribution directly to the account holder. The individual then has 60 calendar days from receipt to deposit the entire amount into a new eligible retirement account. If the full amount is not redeposited within this 60-day window, the distribution is treated as a taxable withdrawal, potentially subject to income taxes and early withdrawal penalties.

A mandatory 20% federal income tax withholding applies to indirect rollovers from a 401(k) by the plan administrator, even if the individual intends to complete the rollover. To avoid the distribution being considered taxable, the account holder must deposit the full original distribution amount into the new account, potentially using other funds to cover the withheld 20%. The withheld amount is then credited back to the individual when they file their income tax return.

Funds can be rolled into a Traditional IRA, allowing continued tax-deferred growth. Alternatively, funds can be rolled into a Roth IRA, though this typically involves a “Roth conversion” for pre-tax 401(k) funds. A Roth conversion is a taxable event where the converted amount is included in the individual’s gross income for the year of conversion. Once converted, qualified withdrawals from the Roth IRA in retirement are tax-free.

Understanding Cashing Out

Cashing out a 401(k) means taking a lump-sum distribution directly, rather than transferring funds to another retirement account. This action has immediate and substantial financial consequences due to taxes and penalties. It is generally not recommended unless facing extreme hardship, as it significantly depletes retirement savings.

The entire distribution from a traditional 401(k) is typically taxed as ordinary income in the year it is received. This amount is added to the individual’s other income and is subject to their marginal income tax rate. State income taxes may also apply, depending on the individual’s state of residence.

A mandatory 20% federal tax withholding is applied to the distribution by the plan administrator. This 20% is an upfront withholding, not necessarily the total tax owed. Actual tax liability depends on the individual’s overall income and tax bracket, and they may owe more or receive a refund when filing their tax return.

A 10% early withdrawal penalty applies to distributions taken before age 59½, levied on top of ordinary income taxes. For instance, if a person under 59½ cashes out $10,000, they could immediately lose $2,000 to federal withholding and an additional $1,000 to the early withdrawal penalty, before accounting for any state taxes or their actual income tax bracket.

There are specific exceptions to the 10% early withdrawal penalty, including total and permanent disability, certain unreimbursed medical expenses, and distributions made after separation from service at age 55 or older (or age 50 for most public safety employees). Other exceptions include qualified domestic relations orders (QDRO) or distributions for certain federally declared disasters or birth/adoption expenses. Even with an exception, the distribution remains subject to ordinary income tax. Cashing out irrevocably reduces the money available for retirement and forfeits future tax-deferred growth.

Key Factors in Your Decision

When deciding what to do with an old 401(k), several factors warrant consideration beyond just the mechanics of the transfer. Fees and expenses associated with retirement accounts can impact long-term growth. Individuals should compare administrative fees, investment management fees, and expense ratios across their old 401(k) plan, any new employer’s 401(k), and various IRA options. Higher fees, even seemingly small percentages, can erode a substantial portion of savings over decades.

The range and quality of investment options available in each account type are important. Some employer-sponsored 401(k) plans may have a limited selection of investment funds, while an IRA typically offers a much broader universe of choices, including individual stocks, bonds, mutual funds, and exchange-traded funds. Evaluating whether existing investments align with personal risk tolerance and financial goals, and if better options are available elsewhere, is a prudent step.

Considering access to funds involves weighing liquidity against long-term protection. While cashing out provides immediate access to funds, it comes at a high cost in taxes and penalties, undermining retirement security. Rollovers, conversely, keep funds protected within tax-advantaged retirement vehicles, preserving their growth potential for their intended purpose.

Creditor protection is another valuable aspect of retirement accounts. Employer-sponsored 401(k) plans generally receive robust protection from creditors under the Employee Retirement Income Security Act (ERISA). This federal law sets standards for private-sector retirement plans and typically shields assets from lawsuits and bankruptcy. While IRAs also offer some bankruptcy protection under federal law, their protection from other creditors often depends on state laws, which can vary significantly.

Future contributions and plan rules should influence the decision. If a new employer’s 401(k) offers attractive features like matching contributions or a Roth 401(k) option, consolidating funds there might be advantageous. However, if the new plan has high fees or limited investment choices, an IRA might offer more flexibility for future contributions and investment management.

Ultimately, the best choice depends on an individual’s unique financial situation, including their current income, future earning potential, need for liquidity, and comfort with managing investments. Consulting with a qualified financial advisor or tax professional is advisable for personalized guidance tailored to specific circumstances. They can help assess tax implications, evaluate investment strategies, and navigate the administrative processes involved in transferring retirement funds.