What to Do With a 401(k) From a Previous Employer

When transitioning between employers, individuals often encounter a common financial decision: what to do with their accumulated 401(k) savings from a previous job. Making an informed choice about these funds is a significant step for maintaining long-term financial health and retirement planning. Each option presents distinct implications, and understanding these can help in navigating the complexities of retirement account management.

Leaving Your 401(k) with Your Former Employer

One option is to leave your 401(k) funds with your former employer. The money continues to grow within the existing investment framework, though you cannot make new contributions. Many plans permit former employees to keep funds if the balance exceeds $5,000. If the vested balance is less than $1,000, the employer might automatically cash out the account. Balances between $1,000 and $5,000 may be rolled into an Individual Retirement Account (IRA) of the employer’s choosing.

Leaving funds in an old plan limits investment options to what the plan offers, which might not align with your current financial goals or risk tolerance. These plans often have administrative and investment management fees that can impact returns. Former employees may face different fee structures, sometimes incurring higher costs like a monthly maintenance fee. These fees, typically 0.5% to 2% annually, can accumulate and significantly reduce the account’s value.

Rolling Over Your 401(k)

Rolling over a 401(k) involves moving funds from your previous employer’s plan into another qualified retirement account. This common strategy offers increased control and flexibility over your retirement savings. Funds can be transferred to a new employer’s 401(k) plan, if permitted, or into an IRA.

Individuals typically choose between a Traditional IRA or a Roth IRA. Moving funds to a Traditional IRA maintains tax-deferred status, with taxes paid upon withdrawal in retirement. Conversely, rolling over pre-tax 401(k) funds into a Roth IRA is a taxable event. The converted amount becomes subject to income tax in the year of conversion, but qualified withdrawals in retirement are tax-free.

Before initiating a rollover, gather details about your old 401(k) account, including account numbers and custodian contact information, and details for the new receiving account. The preferred method is a direct rollover, where funds are transferred electronically or via a check payable directly to the new account custodian. This method ensures funds never pass through your hands, avoiding potential tax withholding and penalties. To initiate a direct rollover, contact your former plan administrator, complete forms, and provide details of your new retirement account. The plan administrator then directly transfers funds to the new custodian.

An alternative, less recommended method is an indirect rollover, also known as a 60-day rollover. With this approach, funds are distributed directly to you, and you have 60 days to deposit the full amount into a new qualified retirement account. A significant drawback of an indirect rollover from a 401(k) is the mandatory 20% federal income tax withholding applied by the plan administrator. To complete the rollover and avoid taxes and penalties, you must deposit the entire original distribution amount, including the 20% withheld, within the 60-day window, often requiring other personal funds to cover the withheld portion. If funds are not redeposited within 60 days, the distribution becomes taxable income, and if you are under age 59½, it may also incur an additional 10% early withdrawal penalty.

Cashing Out Your 401(k)

Cashing out a 401(k) involves taking a full distribution of funds as taxable income, rather than preserving them for retirement. The entire amount distributed from a traditional 401(k) is considered ordinary income and is subject to federal income tax at your current marginal tax rate, along with any applicable state income taxes. For example, a $25,000 withdrawal could result in significant federal income tax, potentially alongside state taxes, depending on your income and state of residence.

In addition to income taxes, distributions taken before age 59½ are subject to an additional 10% early withdrawal penalty imposed by the IRS. This penalty applies to the full distribution amount. For instance, a $25,000 withdrawal could incur a $2,500 penalty. There are specific exceptions to this 10% penalty, such as separation from service at age 55 or older, total and permanent disability, certain unreimbursed medical expenses exceeding 7.5% of adjusted gross income, or distributions made as a series of substantially equal periodic payments. However, even if an exception applies, the distribution remains subject to ordinary income tax.

When cashing out, the plan administrator is required to withhold 20% of the distribution for federal income taxes. This withholding is an upfront payment towards your tax liability, but it may not cover the full amount owed, potentially leading to additional taxes due at tax time. After requesting a distribution from your former employer’s plan administrator, you will need to complete specific distribution forms. For tax reporting purposes, the plan administrator will issue Form 1099-R, which reports the distribution amount and any taxes withheld. Cashing out a 401(k) is an irreversible decision that removes funds from tax-deferred growth, significantly impacting future retirement savings.