What Happens to Your 401k If You Leave Your Job?

A 401(k) plan is an employer-sponsored retirement savings account. Employees contribute a portion of their earnings, often pre-tax, and employers may also contribute through matching programs. The funds typically grow tax-deferred until retirement. When leaving a job, a decision must be made regarding the accumulated assets in your former employer’s 401(k) plan.

Leaving Your 401k with Your Former Employer

One option is to leave your 401(k) assets within your former employer’s plan. This is often permissible if your account balance is above $5,000. If the vested balance is below this, the plan administrator might issue a cash distribution or automatically roll the funds into an individual retirement account (IRA). For balances between $1,000 and $7,000, an automatic rollover to an IRA is also common if no action is taken.

To determine if keeping funds in the old plan is feasible, contact the former plan administrator to verify rules, fees, and investment options. Leaving funds in the existing plan generally does not trigger immediate tax consequences.

Rolling Over to a New Employer’s Plan

Moving your retirement savings from a previous employer’s 401(k) to your new employer’s plan is known as a rollover. This process allows your retirement assets to continue growing with tax advantages. Consult your new employer’s plan administrator for eligibility, investment options, and instructions for accepting rollovers.

The most common method is a direct rollover, where funds are transferred directly from your old plan to your new plan. This trustee-to-trustee transfer avoids tax withholding and penalties. You will typically need to complete forms from both providers.

An alternative is an indirect rollover, where funds are distributed to you. The plan administrator is legally required to withhold 20% for federal income tax. You then have 60 days to deposit the full amount into your new plan or another eligible retirement account. Failing to meet this deadline means the distribution is taxable income, and if you are under age 59½, it may also incur an additional 10% early withdrawal penalty.

Transferring to an Individual Retirement Account

Transferring your 401(k) balance to an Individual Retirement Account (IRA) is another option, offering a wider array of investment choices and greater control. You will need to decide between a Traditional IRA or a Roth IRA, each with distinct tax implications. For a Traditional IRA, funds generally continue to grow tax-deferred.

For a direct rollover to an IRA, funds move electronically or via a check made payable to the IRA custodian, ensuring the money never passes through your hands. This method avoids immediate taxation and withholding. Contact your former 401(k) administrator to arrange this transfer.

An indirect rollover to an IRA involves you receiving the funds directly. The plan administrator will withhold 20% for federal income tax. You have 60 days to deposit the entire amount, including the withheld portion, into your IRA to avoid income taxes and penalties if you are under age 59½. If you convert a pre-tax 401(k) to a Roth IRA, the entire converted amount will be treated as taxable income in the year of conversion.

Cashing Out Your 401k

Cashing out your 401(k) means taking a full distribution of the funds from your account. This action is generally not advisable due to significant financial drawbacks. To initiate this, you would request a distribution from your former plan administrator.

The most substantial consequence is the immediate tax burden. Any pre-tax contributions and earnings are fully taxed as ordinary income. If you are under age 59½, you will generally incur a 10% early withdrawal penalty. Limited exceptions to this penalty include separating from service in or after the year you turn age 55 (Rule of 55), becoming totally and permanently disabled, or distributions for certain unreimbursed medical expenses.

Even with an exception, the distribution remains subject to ordinary income tax. The plan administrator is legally required to withhold 20% for federal income tax. This mandatory withholding may not cover your entire tax liability.