What Should You Do With an Old 401k?

Many individuals find themselves with an old 401(k) from a previous employer when transitioning between jobs. Managing this retirement account is an important financial decision. These funds are accumulated savings for retirement, and handling them thoughtfully impacts long-term financial security. Understanding the available options allows individuals to make informed choices that align with their financial strategies.

Understanding Your Options

When you leave an employer, your old 401(k) offers several management options. You can leave the funds in the former employer’s plan, generally permissible if the balance exceeds a threshold, often $5,000. For smaller balances, the plan administrator may automatically roll over funds into an Individual Retirement Account (IRA) or disburse them, potentially triggering immediate tax consequences.

Another option is rolling over funds into your new employer’s 401(k) plan, if it accepts incoming rollovers. Consolidating assets into a single plan can simplify management and provide a unified view of your retirement savings.

Many choose to roll over their old 401(k) into a Traditional IRA. This maintains the tax-deferred status of the funds, with taxes paid only upon retirement withdrawals. It also offers a broader range of investment choices than employer-sponsored plans.

Alternatively, you can roll over pre-tax 401(k) funds into a Roth IRA, known as a Roth conversion. This is a taxable event, as you pay income tax on the converted amount in the year of conversion. However, qualified distributions from a Roth IRA in retirement are entirely tax-free, including earnings.

A final option, generally discouraged due to significant penalties, is cashing out the 401(k). This lump-sum distribution is immediately subject to ordinary income tax. For individuals under age 59½, it typically incurs an additional 10% early withdrawal penalty, as outlined in Internal Revenue Code Section 72.

Key Considerations Before Deciding

Before deciding on your old 401(k), evaluate several factors influencing your retirement savings’ long-term growth and accessibility. Investment choices vary significantly between old 401(k)s, new 401(k)s, and IRAs. Employer plans may offer limited funds, while IRAs generally provide a broader array of investment vehicles, including stocks, bonds, and various mutual funds or exchange-traded funds.

Fees associated with retirement accounts can erode returns. Compare administrative fees, investment management fees, and other charges across options. Understanding the fee structure of each potential destination is important for maximizing savings.

Creditor protection is another consideration. Funds in 401(k) plans generally receive strong protection from creditors under the Employee Retirement Income Security Act (ERISA). Creditor protection for IRAs varies, with federal bankruptcy laws providing some safeguards, but state laws often dictate protection in other circumstances.

Required Minimum Distributions (RMDs) typically begin at age 73 for both 401(k)s and IRAs. A specific exception for 401(k)s allows you to delay RMDs from that plan until retirement if you are still working for the employer and are not a 5% owner.

Access to funds before retirement also differs. The “Rule of 55” allows penalty-free withdrawals from a 401(k) if you leave your job at age 55 or older. This rule does not apply to IRAs, where the general 10% early withdrawal penalty applies for distributions before age 59½, unless another exception applies.

Some 401(k) plans offer loan provisions, a feature not available with IRAs. This option provides access to funds for short-term needs without triggering immediate taxes or penalties, provided loan terms are met.

Executing a Rollover

Once you decide on the path for your old 401(k), the next step is executing the transfer. The most common method is a direct rollover, also known as a trustee-to-trustee transfer. Funds are transferred directly from your old 401(k) plan administrator to the new account custodian, bypassing your personal possession. This method ensures funds maintain their tax-deferred status without withholding or penalties.

To initiate a direct rollover, contact your old 401(k) plan administrator. They will provide forms and instructions. You will need to provide details of your receiving account, including the account number and the new custodian’s name and contact information. The plan administrator will then process the transfer directly.

An alternative is an indirect rollover, where a check is issued to you. If you choose this, you have 60 days from receipt to deposit the funds into a new qualified retirement account. A significant pitfall is the mandatory 20% federal income tax withholding applied to the distribution.

If you fail to deposit the full amount, including the 20% withheld, within the 60-day window, the un-rolled-over portion becomes a taxable distribution. This can result in immediate income tax liability and, if under age 59½, an additional 10% early withdrawal penalty. Direct rollovers are preferred to avoid these complexities.

Clear communication with both your old 401(k) administrator and the new account custodian is essential. They will guide you through required documentation, such as rollover request forms. After submitting paperwork, follow up within a few weeks to confirm the successful transfer and proper allocation of funds in your new account.

Tax Reporting for Distributions and Rollovers

Understanding tax implications and reporting requirements is important when managing distributions and rollovers from an old 401(k). After any distribution or rollover, you will typically receive Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form, issued by the financial institution, reports the gross distribution in Box 1. Box 2a shows the taxable amount, while Box 2b indicates if the taxable amount was not determined or if it was a total distribution.

Box 7 of Form 1099-R contains distribution codes specifying the type of distribution. For instance, code ‘G’ indicates a direct rollover, meaning funds were transferred directly to another qualified plan and are generally not taxable. Code ‘1’ might indicate an early distribution, potentially subject to the 10% penalty, while code ‘7’ could represent a normal distribution. These codes are essential for accurately reporting the transaction on your federal income tax return.

If you roll over funds into an IRA, you will also receive Form 5498, “IRA Contribution Information,” from the IRA custodian. This form reports total contributions to your IRA for the year, including rollover contributions. While not used to calculate taxes, it confirms the rollover was received by the IRA and helps the IRS track retirement fund movement.

When preparing your federal income tax return, typically Form 1040, report 401(k) distributions and rollovers on lines 4a and 4b. For a direct rollover, report the gross distribution amount on line 4a and enter “0” on line 4b, indicating it is not taxable, often with “Rollover” written next to it. This documents that funds moved between qualified accounts without triggering a taxable event.

Certain exceptions to the early withdrawal penalty exist. These include distributions due to permanent disability, for unreimbursed medical expenses exceeding a certain percentage of adjusted gross income, for higher education expenses, or for a first-time home purchase, up to a $10,000 lifetime limit.