What to Do With a 401(k) After Leaving a Job?

When an individual separates from their employer, a financial consideration is what to do with their existing 401(k) retirement savings plan. This account, established through workplace contributions, holds significant value for future financial security. Understanding the available options for this account is important to make informed decisions that align with long-term financial goals. Each choice carries distinct implications for the growth, accessibility, and tax treatment of these accumulated funds.

Leaving Your 401(k) with Your Former Employer

One option for a 401(k) account after leaving a job is to leave the funds within the former employer’s plan. This choice allows the account to continue investing according to the plan’s existing investment options. The ability to keep funds in a former employer’s plan often depends on the account balance. Many plans may require a distribution if the vested balance is below a certain threshold, such as $5,000 or $7,000.

If the balance is below a specified amount, for example, less than $1,000, the former employer might issue a check for the balance, effectively cashing out the account. For balances between approximately $1,000 and $7,000, the plan administrator might automatically roll the funds into an Individual Retirement Account (IRA) established in the former employee’s name. If the account balance exceeds these thresholds, generally $5,000 or $7,000, the funds can remain in the plan indefinitely.

Choosing to leave funds in a former employer’s plan means no new contributions can be made to that specific account. While the money continues to grow, investment options might be more limited compared to other retirement vehicles. The account remains subject to the administrative fees charged by the former plan and its rules regarding withdrawals and loan availability. This option also ensures the continued protection of the Employee Retirement Income Security Act (ERISA).

Rolling Over Your 401(k)

A common approach for a 401(k) after changing jobs involves rolling over the funds into another qualified retirement account. The primary reason for this action is to preserve the tax-deferred status of the retirement savings, preventing immediate tax liabilities. This strategy ensures that the accumulated earnings continue to grow without current taxation until retirement.

Rollover to a New Employer’s 401(k) Plan

Moving funds into a new employer’s 401(k) plan is an option if the new plan permits incoming rollovers. This allows for the consolidation of retirement savings into a single, current workplace account, simplifying management. The funds continue to benefit from the structure of an employer-sponsored plan, which may include lower administrative fees than some individual accounts and the availability of plan loans. This option also maintains the funds under ERISA protection, offering legal safeguards.

Rollover to an Individual Retirement Account (IRA)

Transferring a 401(k) into an IRA is a popular choice, offering a broader array of investment opportunities compared to many employer-sponsored plans. This can include a wider selection of mutual funds, exchange-traded funds (ETFs), and individual stocks. When rolling over pre-tax 401(k) funds, they go into a Traditional IRA, maintaining their tax-deferred status. Alternatively, funds can be converted to a Roth IRA, which involves paying taxes on the converted amount at the time of conversion, but then allows for tax-free growth and tax-free withdrawals in retirement, provided certain conditions are met.

Rollover Process

The process of rolling over a 401(k) involves both preparatory steps and procedural mechanics. First, gather information from the former employer’s 401(k) plan administrator regarding their rollover procedures, required forms, and contact details. Next, research the requirements of the new employer’s 401(k) plan or the chosen IRA provider, including account opening procedures, available investment options, and any associated fees.

There are two main methods for transferring funds: a direct rollover and an indirect rollover. A direct rollover, generally the preferred method, involves the funds being transferred directly from the old 401(k) plan administrator to the new plan or IRA custodian without the funds ever being in the individual’s possession. This method avoids mandatory tax withholding and potential complications.

Conversely, an indirect rollover occurs when a check is issued to the individual. In this scenario, the individual must deposit the full amount into an eligible retirement account within 60 days of receiving the distribution to avoid it being considered a taxable withdrawal. If an indirect rollover is chosen, the former 401(k) plan is required to withhold 20% of the distribution for federal income tax. To complete the rollover of the full amount and avoid tax consequences, the individual must deposit not only the amount received but also make up the 20% that was withheld from other personal funds.

Cashing Out Your 401(k)

Directly withdrawing the funds from a 401(k) as a lump sum is an option, though it carries significant financial implications. Any amount withdrawn from a traditional 401(k) is immediately subject to ordinary income tax. This means the distribution is added to your taxable income for the year, potentially pushing you into a higher tax bracket.

In addition to income tax, if the individual is under age 59½, an additional 10% penalty applies to the withdrawn amount. There are limited exceptions to this penalty, but in most cases, it significantly reduces the net amount received. Furthermore, the plan administrator is required to withhold 20% of the distribution for federal income tax at the time of withdrawal.

While some individuals consider cashing out for immediate financial needs or if their account balance is very small and subject to mandatory distribution by the plan, this action can substantially diminish retirement savings. The combined effect of income taxes, the additional penalty, and mandatory withholding means that a significant portion of the original balance will be lost. This choice also sacrifices the future tax-deferred growth that the funds would have experienced, potentially compromising long-term financial security.