What to Do With Your 401(k) After Being Laid Off?

After a layoff, a key financial decision involves your 401(k) retirement savings. Understanding the available options for these funds is important for preserving your financial security.

Available Options for Your 401(k)

Upon separation from an employer, your 401(k) funds present four primary options. Each choice has distinct characteristics impacting accessibility, investment control, and tax treatment.

You can leave the funds within your former employer’s 401(k) plan, provided the plan allows it. This option maintains the money in its current investment structure.

Another common choice is rolling over the funds into an Individual Retirement Account (IRA). An IRA offers a personal retirement vehicle with different levels of investment control and flexibility.

If you secure new employment that offers a 401(k), you might roll over your previous plan’s funds into your new employer’s 401(k). This consolidates your retirement savings into a single workplace account.

The final option involves cashing out your 401(k). While this provides immediate access to funds, it carries significant tax implications and penalties. This choice is generally a last resort due to its potential long-term financial consequences.

Key Considerations for Each Choice

Deciding on the best course of action for your 401(k) involves evaluating several factors, including tax implications, investment flexibility, associated fees, and future access to funds. Each option presents a different set of advantages and disadvantages.

Tax Implications

Leaving funds in your former employer’s 401(k) or rolling them over to an IRA or new employer’s 401(k) allows savings to continue growing tax-deferred, postponing taxation until retirement. Cashing out immediately triggers income tax on the distribution. If you are under age 59½, an additional 10% early withdrawal penalty applies, unless an exception is met.

One exception to the early withdrawal penalty is the “Rule of 55,” which applies if you leave your job in or after the year you turn 55. Under this rule, you can take penalty-free distributions from the 401(k) plan of the employer you separated from. These withdrawals are still subject to ordinary income tax. This rule does not apply if funds are rolled over into an IRA.

When performing a rollover, a direct rollover is advisable, where funds are transferred directly from the old plan administrator to the new account custodian. This method avoids tax withholding and ensures the entire amount is rolled over. In an indirect rollover, funds are distributed to you, and you have 60 days to deposit the money into another eligible retirement account. If the 60-day deadline is missed, the distribution becomes taxable and may incur the 10% early withdrawal penalty if you are under 59½. For indirect rollovers from a 401(k), a mandatory 20% federal income tax withholding is applied, meaning you need other funds to roll over the full amount to avoid immediate taxation.

Investment Options

The range of investment choices varies significantly among the options. Employer-sponsored 401(k) plans offer a limited selection of funds. While this can simplify investment decisions, it may restrict access to a broader market of investment products.

Rolling over to an IRA provides a much wider array of investment options, including individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs), allowing for greater customization of your portfolio. A new employer’s 401(k) plan will also have a specific set of investment choices. Consolidating funds into a single account, whether a new 401(k) or an IRA, can simplify portfolio management.

Fees and Expenses

Fees impact the long-term growth of your retirement savings. 401(k) plans often include administrative and investment-specific fees, such as expense ratios for mutual funds. These fees vary significantly between plans.

IRAs offer more control over fees. Many online brokers provide IRAs with no account maintenance fees and commission-free trading for many investments. However, investment-level fees, like expense ratios for mutual funds or advisory fees for managed accounts, still apply. Comparing fee structures is important, as even small differences accumulate over time.

Access to Funds

The standard age for penalty-free withdrawals from both 401(k)s and IRAs is 59½. The Rule of 55 allows penalty-free access to 401(k) funds from your most recent employer if you separate service in or after the year you turn 55. This exception does not extend to IRAs.

Other exceptions to the 10% early withdrawal penalty for both 401(k)s and IRAs include distributions due to total and permanent disability, certain unreimbursed medical expenses, or substantially equal periodic payments. Some 401(k) plans may permit loans, which are not available from IRAs.

Creditor Protection

The level of protection your retirement funds receive from creditors differs based on the account type. 401(k)s, as ERISA-qualified plans, offer strong federal creditor protection, shielding assets from most judgments.

IRAs offer some federal protection in bankruptcy. However, their protection from creditors outside of bankruptcy varies and depends on state laws. This difference in protection can be a factor for individuals concerned about potential legal claims.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are amounts that must be withdrawn from traditional retirement accounts annually once you reach age 73. Both 401(k)s and IRAs are subject to RMD rules.

If you continue working past age 73, you may delay RMDs from your current employer’s 401(k) plan until you retire. This RMD delay does not apply to IRAs. Rolling funds into a new employer’s 401(k) can allow you to continue delaying RMDs if you remain employed with that company.

Steps to Implement Your Decision

Once you decide on the best path for your 401(k) after a layoff, executing that decision involves specific procedural steps. These steps ensure a smooth transfer or distribution of your retirement funds.

For Leaving Funds with the Former Employer’s Plan

If you choose to leave your funds in the old 401(k), verify with your former employer or the plan administrator that this is permissible. Some plans may automatically force out smaller accounts, especially if your balance is below a certain threshold (e.g., $5,000 or $7,000). Confirm your contact information, including mailing address and email, is up to date with the plan administrator. You will no longer be able to contribute to this account, but you can continue to manage its investments within the plan’s offerings.

For Rolling Over to an IRA

To initiate a direct rollover to an IRA, first open a new IRA account with a financial institution of your choice. You will need your old 401(k) account number and the details of your new IRA custodian. Contact your former 401(k) plan administrator to request a direct rollover, specifying that funds should be sent directly to your new IRA custodian. The plan administrator will provide necessary forms, such as a distribution request form and rollover instructions. This method ensures funds are transferred without passing through your hands, avoiding tax withholding.

For an indirect rollover, request a distribution check made out to you from your former 401(k) plan. The plan administrator will withhold 20% for federal income tax from this check. You then have 60 days from the date you receive the distribution to deposit the full amount (including the 20% withheld) into your new IRA. If you do not deposit the full amount within this timeframe, the unrolled portion will be considered a taxable distribution and may incur penalties if you are under 59½.

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

Before initiating this type of rollover, confirm with your new employer’s 401(k) plan administrator that their plan accepts rollovers from previous employer plans. Gather necessary information, including your old 401(k) account details and the new plan’s rollover instructions and account information. You will then contact your former 401(k) plan administrator to request a direct rollover of funds to your new employer’s plan. This process often involves coordinating between the two plan administrators to ensure a seamless transfer.

For Cashing Out

If you decide to cash out your 401(k), contact your former 401(k) plan administrator to request a lump-sum distribution. A mandatory 20% federal income tax withholding will apply to the distribution. The distributed amount will be added to your taxable income for the year. If you are under 59½, a 10% early withdrawal penalty will be assessed on top of the income tax, unless an exception applies.