What Should You Do With Your 401(k) When Leaving a Job?

A 401(k) plan serves as a tax-advantaged retirement savings vehicle, allowing contributions and employer matching funds to grow tax-deferred until retirement. When an individual leaves a job, they face several distinct choices regarding their accumulated 401(k) funds. Each option carries its own set of considerations, including potential tax implications, administrative processes, and access to investment opportunities, which require careful evaluation to align with personal financial goals.

Leaving Your 401(k) with Your Former Employer

One option is to leave 401(k) funds within the former employer’s plan. This allows accumulated savings to continue growing under the existing plan’s investment options and administrative structure. Many plans permit former employees to retain their accounts, particularly if the balance exceeds a certain threshold, commonly $5,000. Plans may automatically roll over accounts with balances below a certain amount, such as $1,000 or $5,000, into an IRA if the participant does not elect another option.

Maintaining the account means continued access to the plan’s specific investment lineup, which may include a range of mutual funds or exchange-traded funds. However, this option may present some disadvantages, such as potentially higher administrative fees compared to other retirement savings vehicles or a limited selection of investment choices that may not align with current financial strategies.

Rolling Over Your 401(k) to a New Employer’s Plan

Transferring 401(k) funds from a previous employer’s plan to a new employer’s retirement plan is a common strategy for consolidating retirement savings. This process, often referred to as a rollover, allows funds to maintain their tax-deferred status. The most straightforward method is a direct rollover, where funds are transferred electronically or via check made payable directly to the new plan administrator or custodian. This direct transfer avoids any temporary distribution to the individual, preventing tax withholding and potential penalties.

An alternative is an indirect rollover, where funds are first distributed to the individual. The plan administrator is required to withhold 20% of the distribution for federal income tax purposes. The individual then has 60 days from the date of receipt to deposit the full amount, including the 20% that was withheld, into the new employer’s plan or another eligible retirement account.

If the entire amount is not redeposited within this 60-day window, the unrolled portion becomes taxable income. If the individual is under age 59½, a 10% early withdrawal penalty may also apply. Before initiating a rollover, evaluate the new plan’s investment options, fee structure, and eligibility requirements.

Rolling Over Your 401(k) to an IRA

Rolling over 401(k) funds into an Individual Retirement Account (IRA) is another common strategy after leaving a job. This option provides greater flexibility and a broader array of investment choices compared to employer-sponsored plans. To initiate this process, an individual generally needs to open an IRA if they do not already have one, then coordinate the transfer of funds from the former 401(k) plan administrator to the IRA custodian.

When rolling over a pre-tax 401(k) to an IRA, individuals can choose between a Traditional IRA or a Roth IRA. Rolling over to a Traditional IRA maintains the tax-deferred status of the funds, meaning taxes will only be paid upon withdrawal in retirement. Alternatively, individuals can convert their pre-tax 401(k) funds to a Roth IRA, which is a taxable event. The amount converted from the pre-tax 401(k) to the Roth IRA will be added to the individual’s taxable income in the year of conversion, but qualified withdrawals from the Roth IRA in retirement will be tax-free.

Similar to rollovers to a new employer’s plan, rollovers to an IRA can be executed as a direct or indirect transfer. A direct rollover, where funds move directly from the 401(k) custodian to the IRA custodian, is preferred as it avoids the mandatory 20% federal tax withholding. If an indirect rollover occurs, the 20% withholding applies, and the individual must deposit the full amount of the distribution into the IRA within 60 days to avoid taxation and potential early withdrawal penalties. IRAs generally offer an expansive selection of investment products, including individual stocks, bonds, mutual funds, and exchange-traded funds, providing more control over investment diversification and asset allocation.

Cashing Out Your 401(k)

Cashing out a 401(k) involves taking a full distribution of the funds directly as a taxable withdrawal, rather than transferring them to another retirement account. This action has substantial financial consequences due to the significant tax burden and loss of future tax-deferred growth. The distributed funds are taxed as ordinary income at the individual’s marginal tax rate for the year of the withdrawal.

If the individual is under age 59½ at the time of the distribution, a 10% early withdrawal penalty applies to the taxable portion, as outlined in Internal Revenue Code Section 72. Exceptions to this penalty include distributions made due to death or total and permanent disability of the participant. Other exceptions include distributions that are part of a series of substantially equal periodic payments (SEPPs) made over the life expectancy of the individual, distributions for certain unreimbursed medical expenses exceeding 7.5% of adjusted gross income, and distributions for qualified higher education expenses. Additionally, withdrawals up to $10,000 for a first-time home purchase or up to $5,000 for qualified birth or adoption expenses may also be exempt from the 10% penalty. Requesting a distribution involves contacting the former plan administrator and completing specific forms.