What Should You Do With Your 401k When Retiring?

Retirement marks a significant life transition, often accompanied by complex financial decisions. For many individuals in the United States, a 401(k) plan represents a substantial portion of their accumulated retirement savings. Understanding the various options available for these funds upon leaving employment is paramount. This decision impacts not only immediate financial liquidity but also long-term tax obligations and investment flexibility.

Your 401k Options at Retirement

Upon retiring, you have several choices for managing your 401(k) funds. You can leave your assets in your former employer’s 401(k) plan if the administrator allows it. Your investments continue to grow within the existing plan structure. While you no longer receive employer contributions, your funds remain tax-deferred.

You can also roll over your 401(k) into an Individual Retirement Account (IRA). A direct rollover transfers funds directly from your 401(k) administrator to your new IRA custodian. An indirect rollover involves a check issued to you; you then have 60 days to deposit the full amount into an IRA to avoid tax consequences. Both methods maintain the tax-deferred status of your savings.

When rolling over to an IRA, you can choose between a Traditional IRA or a Roth IRA. A Traditional IRA rollover maintains tax-deferred funds, with distributions taxed in retirement. Converting a pre-tax 401(k) to a Roth IRA requires paying income taxes on the converted amount in the year of conversion. This can be beneficial if you anticipate being in a higher tax bracket in retirement.

If you retire from one job and start another, you might roll your old 401(k) funds into your new employer’s plan. This consolidates your retirement savings, simplifying management. Eligibility depends on your new employer’s 401(k) plan rules.

Finally, you can cash out your 401(k) by taking a lump-sum distribution. This means receiving the entire account balance directly. This has significant immediate tax implications, as the distribution is taxed as ordinary income. If you are under age 59½, a 10% early withdrawal penalty applies to the taxable portion.

For lump-sum distributions or indirect rollovers, your 401(k) plan administrator must withhold 20% for federal income taxes. This withholding applies even if you intend to complete an indirect rollover within 60 days. To avoid tax liabilities and penalties, you must deposit the entire original distribution, including the withheld 20%, into your new IRA or qualified plan.

Key Considerations for Your Decision

Several factors influence your 401(k) decision upon retirement. Investment options and fees differ between a former employer’s 401(k), an IRA, and a new employer’s 401(k). IRAs often provide broader investment choices, including stocks, bonds, mutual funds, and exchange-traded funds, with potentially lower administrative fees than some employer plans.

Required Minimum Distributions (RMDs) are another consideration, with rules varying by account type. RMDs generally begin from Traditional IRAs and 401(k)s at age 73. If you are still working for the employer sponsoring your 401(k) and are not a 5% owner, you may delay RMDs from that 401(k) until you retire from that employer.

Accessing funds before age 59½ has different rules. While a 10% early withdrawal penalty generally applies to both 401(k)s and IRAs before this age, 401(k) plans may offer the “Rule of 55.” This rule allows individuals who leave their employer at age 55 or later to withdraw funds from that 401(k) without the 10% early withdrawal penalty. This exception does not apply if you roll the funds into an IRA.

Creditor protection is another factor. 401(k) funds generally receive strong federal protection from creditors under the Employee Retirement Income Security Act (ERISA). While IRAs offer some federal protection in bankruptcy, their protection outside of bankruptcy varies more by state law.

Estate planning also plays a role. Rules for designating beneficiaries and distributing inherited assets differ between 401(k) plans and IRAs. IRAs often offer more flexibility in beneficiary designation and allow non-spouse beneficiaries to stretch distributions over their lifetime through inherited IRA rules.

Managing tax obligations is a continuous concern in retirement. Rolling funds into a Traditional IRA allows continued tax-deferred growth, with later distributions taxed as ordinary income. A Roth IRA conversion involves paying taxes upfront, but qualified distributions in retirement are tax-free, offering a strategy to manage future taxable income.

Executing Your Chosen Path

After deciding the best path for your 401(k) funds, implement your choice with practical actions. Gather necessary information from your former 401(k) administrator, including your account number, current balance, and required forms for distributions or rollovers. If rolling over funds, you will also need information from your new IRA custodian, such as account opening forms and direct rollover instructions.

Obtain and accurately complete the forms provided by your 401(k) plan administrator. These forms guide you through the distribution process and require you to indicate your preference: a direct rollover, an indirect rollover, or a lump-sum cash out. For a direct rollover, ensure you designate the new IRA custodian or new employer’s 401(k) plan as the recipient.

If you opt for an indirect rollover or a cash-out, you must deposit the entire original distribution amount, including the withheld 20%, into your new IRA within 60 days to avoid tax penalties and ensure a tax-free rollover. You will need to use other funds to cover the 20% initially withheld by the administrator.

Once forms are completed, submit them according to your 401(k) administrator’s instructions (online, mail, or fax). Following submission, track the transfer or distribution of your funds. For direct rollovers, funds are typically transferred electronically, which can take several business days or weeks.

Confirming fund receipt by the new custodian or into your personal account is a final step. For rollovers, verify the full amount has been credited to your new IRA or 401(k). Anticipate receiving tax documentation, such as Form 1099-R from your 401(k) administrator, which reports the distribution. If you performed an IRA rollover, your IRA custodian will issue Form 5498, confirming the contribution.