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

When transitioning between jobs, individuals often face decisions about their accumulated 401(k) assets. Several distinct paths exist for managing these funds, each with its own implications for access, growth, and taxation. This article explores the various options to help individuals make informed decisions about their retirement savings. The information provided is for educational purposes only and does not constitute financial or tax advice.

Leaving Your Funds in the Former Employer’s Plan

One option for managing a 401(k) after leaving a job is to simply leave the funds within the former employer’s retirement plan. This choice often serves as a default if no other action is taken. Some plans may have specific rules regarding minimum account balances, including “force-out” provisions. These provisions allow plans to automatically transfer small balances, commonly between $1,000 and $7,000, into an Individual Retirement Account (IRA) if the former employee does not make an election. Review the former employer’s plan documents to understand any such thresholds or conditions.

Leaving funds in the old plan offers advantages, such as continued creditor protection under federal law, specifically the Employee Retirement Income Security Act (ERISA). ERISA shields 401(k) assets from most creditors and bankruptcy proceedings. Familiarity with existing investment options within the plan can also be a benefit. Some individuals might find the fees associated with their former employer’s plan to be favorable compared to certain other retirement vehicles.

There are also potential disadvantages. Individuals may have limited control over investment choices, as they are restricted to the options provided by the former plan administrator. Fees could be higher for former employees than for active participants, or the plan administrator might decide to move the entire plan to another provider.

Tracking multiple retirement accounts from various past employers can become difficult, and new contributions cannot be made to a 401(k) from a former employer. Contact the plan administrator to understand the specific fees, investment options, and any conditions for keeping the funds in the plan.

Rolling Over Your 401(k)

Rolling over a 401(k) involves transferring funds from a former employer’s plan into another qualified retirement account. This process is often recommended for its flexibility and continued tax benefits. This can be accomplished through a direct rollover, where funds are moved directly from the old plan to the new account without the individual taking possession of the money. Alternatively, an indirect rollover involves the funds first being paid to the individual, who then has 60 days to deposit them into another eligible retirement plan. A direct rollover is generally preferred as it avoids mandatory tax withholding and the risk of missing the 60-day deadline.

The two primary destinations for a 401(k) rollover are a new employer’s 401(k) plan or an Individual Retirement Account (IRA). Rolling funds into a new employer’s 401(k) is possible if the new plan accepts rollovers, which can simplify retirement savings by consolidating assets in one place. When considering this option, evaluate the new plan’s investment options, fee structure, and any loan provisions. This choice maintains the federal creditor protection offered by ERISA-qualified plans.

Alternatively, rolling over funds to an IRA provides greater investment flexibility and a wider range of investment choices compared to most employer-sponsored plans. An IRA rollover can be directed to a Traditional IRA, where funds continue to grow tax-deferred, or a Roth IRA. Converting a traditional 401(k) to a Roth IRA involves paying taxes on the converted amount in the year of conversion, as Roth accounts are funded with after-tax dollars and offer tax-free withdrawals in retirement, provided certain conditions are met.

While IRAs do not have the same ERISA protection as 401(k)s, they receive federal creditor protection in bankruptcy up to a certain limit, and rollover IRAs generally retain substantial protection.

To initiate a rollover, individuals need to gather specific information and follow a process:

• Gather account numbers, contact details for rollover processing, and necessary forms from your previous 401(k) plan administrator.
• Obtain account setup requirements and rollover instructions from the new 401(k) plan administrator or IRA custodian.
• Contact the previous plan administrator to request a direct rollover.
• Complete the rollover request form provided by the old plan and provide the details of the receiving account.
• Funds are then transferred directly, often via electronic transfer or a check made payable to the new custodian, usually within a few weeks.

Cashing Out Your 401(k)

Cashing out a 401(k) involves taking a direct distribution of the account balance, which carries significant financial consequences. The entire distribution is generally taxed as ordinary income, adding to the individual’s taxable income for the year. This can potentially push an individual into a higher tax bracket, resulting in a larger tax liability.

In addition to income taxes, a 10% early withdrawal penalty typically applies if the individual is under age 59½ at the time of the distribution. There are specific exceptions to this penalty, such as separation from service at age 55 or older, disability, or certain medical expenses, but these are limited and require meeting specific IRS criteria. The plan administrator is generally required to withhold 20% for federal income tax from the distribution, regardless of the individual’s intent to roll over the funds or their actual tax bracket. Any applicable state taxes may also be withheld.

The procedural action for requesting a cash distribution involves contacting the former employer’s plan administrator and completing a distribution request form. This option is generally not advisable for most individuals due to the substantial tax burden and penalties. The long-term impact on retirement savings from foregone investment growth can be considerable. Cashing out should typically be considered only in absolute financial emergencies, and even then, consulting with a financial advisor is highly recommended to explore all alternatives.