What Happens If I Don’t Rollover My 401k?

A 401(k) plan allows individuals to save for retirement with tax advantages. When changing jobs, you must decide what to do with the funds in that account. While many choose to roll the balance into a new retirement plan, deciding against a rollover can lead to several outcomes with distinct financial implications.

Leaving Your 401(k) with a Former Employer

When you separate from an employer, you may have the option to leave your 401(k) funds within their plan if your vested balance is over $7,000. This means your savings remain subject to the rules of a company you no longer work for. The plan can change its investment options or administrative providers, which could alter your savings without your input.

Employer-sponsored plans charge administrative and investment fees that reduce your returns over time, and these can be higher for former employees. You will still need to manage the account, but accessing statements or making changes might be more cumbersome than with an account you control directly.

The investment choices in a former employer’s 401(k) are limited to a menu selected by the plan sponsor, which can restrict your ability to diversify. The plan’s rules also dictate when and how you can access your money. These withdrawal rules may be less flexible than those for a personal Individual Retirement Account (IRA).

Employer-Initiated Actions for Small Balances

If your vested 401(k) balance is small when you leave your job, your former employer may act without your consent. For balances under $1,000, the plan can perform a “force-out cash-out.” The employer will close the account and mail you a check for the balance, an action that triggers immediate taxes and potential penalties.

For vested balances between $1,000 and $7,000, employers cannot cash you out. Instead, they can perform an “automatic rollover” by transferring your funds into a default Individual Retirement Account (IRA) they establish for you. This transfer is not a taxable event and preserves the tax-deferred status of your savings.

This automatic rollover creates a new responsibility for you. You must locate this new IRA, which may be invested in conservative, low-yield options by default. Once found, you need to manage the investments and be aware of any provider fees that could erode your balance.

The Consequences of Cashing Out Your 401(k)

If you take a cash distribution from your 401(k), your plan administrator must withhold 20% for federal taxes before sending you the money. This amount is a prepayment sent to the IRS. It is only a withholding and may not cover your total tax liability.

Your entire pre-tax 401(k) distribution is considered ordinary income for the year you receive it. This added income can push you into a higher tax bracket. Your total tax liability on the distribution could be much higher than the 20% withheld, depending on your income and state.

If you are under age 59½, the IRS also imposes a 10% early withdrawal penalty on the taxable amount. For example, on a $20,000 cash-out, your employer withholds $4,000 (20%) for federal taxes. If you are in a 22% tax bracket, you would owe $4,400 in income tax plus a $2,000 penalty, for a total of $6,400. Since only $4,000 was withheld, you would owe another $2,400 when filing your taxes, plus any state taxes.

Addressing an Outstanding 401(k) Loan

If you have an outstanding 401(k) loan when you leave your job, most plans require you to repay it in full shortly after. If you cannot repay the balance in time, the unpaid amount is treated as a “loan offset.” This means the loan balance is subtracted from your vested account balance and considered a distribution.

A loan offset is a taxable event. The unpaid loan amount is reported to the IRS as ordinary income for that year. If you are under age 59½, this distribution is also subject to the 10% early withdrawal penalty.

You have until the tax filing deadline for the year of the distribution, including extensions, to avoid taxation on a loan offset. To do this, you must roll the loan offset amount into another eligible retirement plan, like an IRA. If you can replace the offset amount with personal funds and complete the rollover, you can defer the income tax and avoid the penalty.