What Happens to Your 401(k) When You Retire?

Upon retirement, individuals face important decisions regarding their 401(k) savings. These employer-sponsored plans represent a significant portion of many people’s financial assets. Understanding the options for these funds is a crucial step in financial planning, as each choice impacts how your money is managed, accessed, and taxed.

Leaving Funds in Your Former Employer’s Plan

One option for your 401(k) at retirement is to leave the funds within your former employer’s plan. This choice is often available, though it depends on the plan’s specific rules. Some plans may require a minimum account balance, such as $5,000, to keep your funds there.

When funds remain in the plan, they continue to grow on a tax-deferred basis. You can generally start taking penalty-free withdrawals from your 401(k) once you reach age 59½.

Leaving your funds in the old plan means you are subject to its investment options, which might be more limited than those available in an Individual Retirement Account (IRA). Plan fees can vary. A significant advantage of keeping your 401(k) in the employer plan is the strong creditor protection it offers under the Employee Retirement Income Security Act (ERISA), shielding assets from many types of lawsuits and bankruptcy claims.

Rolling Over Your 401(k)

Rolling over your 401(k) involves transferring funds from your former employer’s plan into another qualified retirement account. Many individuals choose this option to gain more control over investments, access a wider array of choices, or consolidate multiple accounts.

There are two primary ways to execute a rollover: a direct rollover and an indirect rollover. A direct rollover, also known as a trustee-to-trustee transfer, involves funds moving directly from your old 401(k) administrator to your new retirement account custodian without you taking possession of the money. This method is generally tax-free and is the most common approach. Funds can be rolled into a Traditional IRA, a Roth IRA, or a new employer’s 401(k) plan.

An indirect rollover means you receive a check for the distribution from your old 401(k) plan. The plan administrator is generally required to withhold 20% of the distribution for federal income tax. To avoid taxes and potential penalties, you must deposit the full amount, including the 20% that was withheld, into another eligible retirement account within 60 days of receiving the funds. If you roll over pre-tax 401(k) funds to a Roth IRA, the converted amount will be treated as taxable income in the year of the conversion, as Roth accounts are funded with after-tax dollars.

To initiate a rollover, contact your former 401(k) plan administrator to request the necessary forms and confirm details with your receiving institution. After submitting forms, verify the transfer with both your former plan and the receiving account custodian.

Taking a Lump-Sum Distribution

Taking a lump-sum distribution means withdrawing your entire 401(k) balance as immediate cash. This option provides direct access to your retirement savings, but it comes with significant tax consequences. The entire distribution is added to your other income for the year and taxed at your ordinary income tax rates.

When you receive a lump-sum distribution, the plan administrator is generally required to withhold 20% for federal income tax. If you are under age 59½, taking a lump-sum distribution may also trigger an additional 10% early withdrawal penalty.

Choosing a lump-sum distribution means forfeiting the continued tax-deferred growth your 401(k) would have provided. The immediate availability of funds must be weighed against this substantial tax impact and the long-term loss of tax-advantaged growth. The 20% withholding might not cover your full tax liability, potentially leaving you with an additional tax bill at filing time.

To request a lump-sum distribution, contact your former 401(k) plan administrator and complete their distribution forms. You will receive IRS Form 1099-R, which reports the amount of the distribution and any taxes withheld, for your tax filing purposes.

Required Minimum Distributions

Required Minimum Distributions (RMDs) are the minimum amounts that must be withdrawn annually from certain retirement accounts once the account holder reaches a specific age. RMDs ensure that deferred taxes on retirement savings are eventually paid to the government. They apply to traditional 401(k)s, 403(b)s, IRAs, and similar tax-deferred plans.

RMDs generally do not apply to Roth IRAs for the original owner, and as of 2024, Roth 401(k)s are also exempt from pre-death RMD rules. The age at which RMDs begin has changed due to the SECURE Act 2.0. For individuals who turned age 73 after December 31, 2022, the RMD starting age is 73; this age will further increase to 75 in 2033.

The amount of your RMD is calculated based on your account balance as of December 31 of the previous year, divided by a life expectancy factor provided by the IRS. RMDs are taxed as ordinary income in the year they are received.

Failing to take a required minimum distribution, or taking less than the required amount, can result in a significant penalty. The penalty for a missed RMD is 25% of the amount not distributed, which can be reduced to 10% if corrected within two years. A special “still working” exception allows individuals who are still employed to delay RMDs from their current employer’s 401(k) plan until they retire, provided they are not a 5% owner of the company. This exception does not apply to IRAs or 401(k)s from former employers.