What Should You Do With Your 401k?

A 401(k) is an employer-sponsored retirement savings plan that provides tax advantages, helping individuals prepare for their financial future. Employees contribute a portion of their wages, often before taxes, into an investment account. Funds within a 401(k) can grow over time, potentially tax-free, until retirement. Many employers also match a percentage of employee contributions, which can significantly boost savings.

A 401(k) allows workers to defer income and invest for retirement with tax benefits. The tax benefit may occur at the time of contribution or when funds are withdrawn. Understanding available options is important for managing your 401(k), especially during life changes or approaching retirement.

Exploring Your 401k Choices

After leaving an employer, several pathways are available for your 401(k) savings. Understanding their characteristics regarding access, taxation, and growth is important for an informed choice.

One option is leaving your 401(k) with your former employer. Your funds continue growing within the previous plan, often without new contributions. Some plans may have minimum balance requirements. Account access, investment selections, and administrative fees are determined by the former employer’s plan rules.

Another consideration is cashing out your 401(k), which involves a full withdrawal. This action has immediate tax consequences, as the withdrawn amount is subject to ordinary income tax. For individuals under age 59½, an additional 10% early withdrawal penalty applies. Cashing out significantly reduces your retirement savings and eliminates future tax-deferred growth.

A third pathway is transferring your 401(k) funds to another qualified retirement account, known as a rollover. This moves your savings from one plan to another without triggering immediate taxes. Transfers can direct funds to a new employer’s 401(k) plan or an Individual Retirement Account (IRA). This approach maintains your retirement savings’ tax-advantaged status while potentially offering different investment opportunities or consolidated management.

Understanding 401k Rollovers

A 401(k) rollover allows individuals to transfer retirement funds from one qualified account to another while maintaining their tax-deferred status. This avoids immediate taxation and penalties that would apply to a withdrawal.

Two primary methods exist for a 401(k) rollover: direct and indirect. In a direct rollover, funds transfer straight from your old 401(k) plan administrator to the new custodian, such as a new 401(k) plan or an IRA. This method ensures funds never pass through your hands, simplifying the process and avoiding mandatory tax withholding.

An indirect rollover involves funds being disbursed to you. You then have a 60-day window to deposit the entire amount into a new qualified retirement account. The plan administrator withholds 20% of the distribution for tax purposes. If you complete the rollover within the 60-day period, you must deposit the full amount, including the 20% that was withheld, to avoid it being treated as a taxable distribution. The withheld amount is reconciled when you file your federal income tax return.

Rolled over funds can be directed to several types of qualified accounts. A common destination is a new employer’s 401(k) plan, if it accepts rollovers. Evaluate factors such as the new plan’s quality, investment options, and associated fees. Consolidating funds into a new employer’s plan can simplify managing your retirement savings.

Alternatively, you can roll over your 401(k) into an Individual Retirement Account (IRA). If your 401(k) funds were pre-tax, they roll into a Traditional IRA, maintaining their tax-deferred status. This option often provides a broader selection of investment choices compared to employer-sponsored plans. If you convert pre-tax 401(k) funds to a Roth IRA, the converted amount is subject to income tax in the year of conversion, but qualified withdrawals in retirement will be tax-free.

Initiating a 401k Rollover

Executing a 401(k) rollover involves specific steps. Begin by gathering all necessary account information from both your former 401(k) administrator and the receiving institution. This includes account numbers, plan names, and contact details for both entities to ensure a smooth transfer.

Next, contact your old 401(k) administrator to initiate the distribution and rollover request. This involves completing specific forms provided by the administrator. Clearly indicate your intention for a rollover and specify whether it will be a direct or indirect transfer.

For a direct rollover, provide the old administrator with your new account details. Funds will be sent directly from your former 401(k) plan to the new retirement account. This method avoids tax withholding and the 60-day deadline.

If you opt for an indirect rollover, the former 401(k) administrator will issue a check payable to you. Remember the 60-day deadline from the date you receive the funds to deposit the entire amount into your new qualified retirement account. Although 20% of the distribution may be withheld, you must deposit the full original amount from other sources to avoid the withheld portion being considered a taxable withdrawal and potentially subject to early withdrawal penalties.

After funds transfer, confirm the rollover’s completion. Verify the balance in your new account. Keep an eye out for tax forms, such as Form 1099-R and Form 5498.

Key Factors for Your 401k Decision

When deciding the future of your 401(k), several factors warrant careful consideration to align the choice with your individual financial goals. Investment options and associated fees differ significantly between account types. Employer-sponsored 401(k)s often provide a limited menu of funds, while IRAs offer a broader selection of investments, including individual stocks, bonds, and exchange-traded funds, along with varied fee structures.

Required Minimum Distributions (RMDs) are amounts you must begin withdrawing from retirement accounts once you reach a certain age. For most individuals, RMDs start at age 73, though specific rules can vary by account type and year of birth. While traditional 401(k)s and IRAs are subject to RMDs, Roth IRAs do not have RMDs for the original owner, offering greater flexibility in retirement.

Creditor protection varies between 401(k)s and IRAs. Funds in 401(k) plans receive strong federal protection under the Employee Retirement Income Security Act (ERISA) from creditors. The level of creditor protection for IRAs can depend on state laws. Understanding these differences is important for safeguarding your retirement savings.

Access to funds before retirement age also presents distinct characteristics. 401(k) plans may offer loans or hardship withdrawals, subject to plan rules and IRS regulations. Loans from a 401(k) must be repaid with interest, and hardship withdrawals are taxable and may be subject to a 10% early withdrawal penalty if you are under age 59½. IRAs do not offer loans, but they have specific exceptions to the 10% early withdrawal penalty for certain circumstances, such as qualified higher education expenses or a first-time home purchase, up to a $10,000 lifetime limit.

Estate planning considerations are relevant, as the treatment of retirement accounts upon the account holder’s death differs. Both 401(k)s and IRAs can be passed to beneficiaries. Distribution rules for inherited accounts vary, impacting tax obligations and withdrawal timelines for heirs. Non-spouse beneficiaries of inherited IRAs are subject to a 10-year rule, requiring the entire account balance to be distributed within a decade of the original owner’s death, though exceptions exist.