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

A 401(k) plan is a tax-advantaged, employer-sponsored retirement savings vehicle that allows individuals to contribute a portion of their income to be invested for their future. Contributions are typically made through payroll deductions and often include an employer match. The primary purpose of a 401(k) is to help individuals build a nest egg that grows tax-deferred until retirement. When employment ends, decisions about these accumulated funds are necessary, as the chosen path has lasting financial implications.

Keeping Your 401(k) with Your Former Employer

One option when leaving a job is to leave your 401(k) funds in your former employer’s plan. This can be a convenient choice, particularly if you are satisfied with the plan’s investment options and fee structure. Your investments will continue to grow or decline based on market performance, maintaining their tax-deferred status.

While this option offers administrative simplicity, you cannot contribute to the plan. Plans may have minimum balance requirements; if your account falls below a certain threshold (often $5,000-$7,000), your former employer might automatically roll over your funds to an Individual Retirement Account (IRA) or issue a taxable distribution. You might also experience higher fees as a former employee, and your control over investment choices may be limited. It is important to regularly track the account and keep beneficiaries updated.

Transferring Your 401(k) to a New Retirement Account

Transferring your 401(k) funds to a new retirement account is a common and often recommended approach, allowing your savings to continue growing with tax advantages. This can involve moving funds to your new employer’s 401(k) plan, if permitted, or to an Individual Retirement Account (IRA), such as a Traditional IRA or a Roth IRA. When deciding where to transfer funds, consider the range of investment options, associated fees, and whether the new plan offers features like loans. IRAs often provide a broader selection of investment choices compared to many employer-sponsored plans.

Before initiating a transfer, gather essential information from your former 401(k) administrator, including account details and contact information. Obtain the necessary contact and account details from the administrator of your new employer’s plan or your chosen IRA custodian. Both institutions will require specific forms. Accurately complete all informational fields, specifying the type of rollover desired. Some plans may also require a letter of acceptance from the receiving institution or spousal consent.

The most common method for moving funds is a direct rollover. In this process, your former plan administrator directly transfers the funds to your new plan administrator or IRA custodian. This direct transfer helps ensure the tax-deferred status of your assets is maintained, avoiding immediate tax implications or penalties. Funds are typically sent via check payable directly to the new institution or through a wire transfer.

An alternative is an indirect rollover, also known as a 60-day rollover. You receive a check payable to you and must deposit the full amount into a new qualified retirement account within 60 days of receipt. If funds are not redeposited within this 60-day window, the Internal Revenue Service (IRS) considers the amount a taxable distribution. The former plan administrator is required by Internal Revenue Code Section 3405 to withhold 20% of the distribution for federal income taxes. If the entire amount, including the 20% withheld, is not deposited within 60 days, the undeposited portion becomes taxable income and may also be subject to a 10% early withdrawal penalty if you are under age 59½, as outlined in Internal Revenue Code Section 72.

Creditor protection is a factor when choosing a rollover destination. Most employer-sponsored 401(k) plans are protected from creditors under the Employee Retirement Income Security Act of 1974 (ERISA). This federal law shields assets within these plans from creditors, civil lawsuits, and bankruptcy. While assets rolled over from an ERISA-qualified plan to an IRA lose their ERISA protection, IRAs receive protection based on state laws, which can vary.

Cashing Out Your 401(k)

Cashing out your 401(k) involves taking a lump-sum distribution of your retirement savings, which has significant financial implications. Any distribution from a traditional 401(k) is considered ordinary income and is subject to federal income tax under Internal Revenue Code Section 61. The withdrawn amount is added to your gross income, potentially pushing you into a higher tax bracket.

Cashing out before age 59½ incurs a 10% early withdrawal penalty, in addition to regular income tax. Specific exceptions to this penalty include:
Distributions made after separation from service at age 55 or older.
For disability.
Certain medical expenses exceeding 7.5% of adjusted gross income.
Qualified domestic relations orders (QDROs).
Birth or adoption expenses (up to $5,000 per child).
Certain emergency personal expenses (up to $1,000 per year).
State income taxes may also apply to the distribution.

To request a cash distribution, contact your former employer’s 401(k) plan administrator for the necessary forms. For eligible rollover distributions, the plan administrator must withhold 20% of the funds for federal income taxes. This withholding applies even if you intend to use the funds for an allowable exception to the 10% penalty, meaning you receive 80% of the distribution initially. After the calendar year of the distribution, you will receive Form 1099-R from the plan administrator, typically by January 31 of the following year. This form reports the gross distribution, taxable amount, and any federal or state income tax withheld, which is necessary for reporting the withdrawal on your annual income tax return.