What to Do With Your 401k After Leaving a Job?

When an individual separates from their employment, a significant financial decision often arises regarding their 401(k) retirement savings. These employer-sponsored plans represent a substantial portion of many people’s long-term financial security. Understanding the available options for managing these funds is important for preserving accumulated savings and avoiding unintended tax consequences.

The various paths for handling a 401(k) after leaving a job include maintaining the account with the former employer, transferring the funds to a different retirement vehicle, or taking a direct cash payout. Each choice carries distinct financial implications that warrant careful consideration. The appropriate course of action depends on individual circumstances, including age, financial needs, and future retirement planning objectives.

Leaving Your 401k with a Former Employer

One option for managing a 401(k) after leaving a job is to leave the funds within the former employer’s retirement plan. The funds remain subject to the plan’s established investment options, which might be limited compared to other account types.

Access rules and administrative fees for the account are governed by the former employer’s plan document. These fees can vary, encompassing investment, administrative, and individual service fees.

Certain plans may impose mandatory distributions if the account balance falls below a specific threshold. For instance, if a vested balance is less than $7,000, some former employers may automatically roll the funds into an Individual Retirement Account (IRA) or, if the balance is very small (e.g., less than $1,000), even cash it out. The existing balance continues to grow on a tax-deferred basis.

Rolling Over Your 401k to Another Retirement Account

Transferring funds from an existing 401(k) to another qualified retirement account is a common strategy for individuals separating from an employer. This process, known as a rollover, allows the funds to maintain their tax-deferred status. Eligible destination accounts include a Traditional IRA, a Roth IRA, or a new employer’s 401(k) plan.

A Traditional IRA and a new employer’s 401(k) typically maintain the pre-tax nature of the original 401(k) funds.

There are two primary methods for executing a rollover: a direct rollover or an indirect rollover. A direct rollover involves the funds being transferred directly from the former employer’s plan administrator to the new account custodian. This method minimizes the risk of tax complications and avoids temporary withholding. To initiate a direct rollover, select the appropriate receiving account and contact your former 401(k) plan administrator. Provide the new custodian’s account details. The plan administrator will typically transfer funds directly to the new custodian.

An indirect rollover means the funds are first distributed to the individual, who then has a limited timeframe to deposit them into a new qualified retirement account. The former 401(k) plan administrator typically applies a mandatory 20% federal income tax withholding to the distributed amount. The individual then has 60 days from the date they receive the distribution to deposit the full amount, including the 20% that was withheld, into the new qualified retirement account. If the full amount is not deposited within this 60-day window, the unrolled portion may be considered a taxable distribution and could be subject to an additional 10% early withdrawal penalty if the individual is under age 59½.

Taking a Cash Distribution from Your 401k

Opting for a cash distribution from a 401(k) involves directly receiving the funds rather than transferring them to another retirement account. Any amount distributed is generally subject to federal income tax at the individual’s ordinary income tax rate in the year it is received.

A mandatory 20% federal income tax withholding typically applies to such distributions. Distributions taken before age 59½ are generally subject to an additional 10% early withdrawal penalty. This penalty is imposed by the IRS to discourage early access to retirement savings.

There are specific exceptions to the 10% early withdrawal penalty, though the distribution remains subject to ordinary income tax. For instance, if an individual leaves their job in the year they turn age 55 or later, distributions from that specific employer’s 401(k) plan may be exempt from the penalty under the “Rule of 55”. Other exceptions include distributions made due to total and permanent disability, certain unreimbursed medical expenses, or distributions for qualified birth or adoption expenses.

Recent legislative changes have also introduced new penalty exceptions. While these exceptions waive the penalty, they do not waive the ordinary income tax liability on the distribution.

Understanding Roth 401k Conversions

A Roth 401(k) conversion involves changing the tax status of retirement funds from tax-deferred to tax-free in retirement. This process typically entails moving pre-tax funds from a traditional 401(k) or Traditional IRA into a Roth account, most commonly a Roth IRA. The primary consequence of this conversion is that the entire converted amount is added to the individual’s gross income for the year of the conversion. The converted amount is then taxed at the individual’s ordinary income tax rate for that year. This immediate tax payment contrasts with the tax-deferred growth of traditional accounts, where taxes are paid upon withdrawal in retirement.

Individuals might consider a Roth conversion if they anticipate being in a higher tax bracket in retirement than they are currently, or if they desire tax-free withdrawals in their later years.

A significant rule associated with Roth conversions is the 5-year rule. Each Roth conversion has its own separate 5-year holding period, which begins on January 1 of the calendar year in which the conversion occurs. This rule dictates that if converted funds are withdrawn before age 59½ and before the completion of their specific 5-year period, the earnings portion of the withdrawal may be subject to a 10% early withdrawal penalty, in addition to income taxes. The 5-year rule for conversions applies independently to each converted amount, meaning multiple conversions each maintain their own distinct 5-year waiting period for penalty-free access to earnings. Once the 5-year period is met and the account holder is age 59½ or older, withdrawals of both contributions and earnings from the converted funds are generally tax-free.

Understanding Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that individuals must take from their traditional 401(k)s and other tax-deferred retirement accounts. RMDs ensure taxes are eventually paid on tax-deferred retirement savings. These distributions are taxed as ordinary income in the year they are received.

The age at which RMDs must begin has changed due to recent legislation. For individuals who turned age 73 in 2023 or later, RMDs generally must begin by April 1 of the year following the year they reach age 73. For those who turn age 74 after December 31, 2032, the RMD age will increase to 75.

Failing to take a full RMD by the specified deadline can result in significant penalties. The IRS imposes an excise tax of 25% on the amount that was not withdrawn as required. This penalty can be reduced to 10% if the shortfall is corrected and the RMD is taken within a two-year period.

Traditional 401(k)s and IRAs are subject to RMDs. However, Roth IRAs do not have RMDs for the original account owner during their lifetime. As of 2024, Roth 401(k) accounts are also exempt from pre-death RMDs for the original account owner.