What to Do With Your 401k When You Leave a Job

A 401k plan is a feature of employment, meaning a change in your job status requires you to make a decision about the accumulated funds. When you leave an employer, the retirement savings in their sponsored plan cannot remain indefinitely. You are presented with several distinct paths for the future of your retirement assets, each with its own rules and financial consequences.

Core Options for Your 401k

When you separate from an employer, you have four primary choices for your 401k assets.

• Leave the funds within your former employer’s plan. This option is typically available if your vested balance is above a certain amount. If your balance is below the plan’s threshold, the plan may initiate a “force-out.” For balances forced out that are over $1,000, the plan is required to roll the funds into a default IRA on your behalf.
• Move the money to your new employer’s retirement plan, if they offer one and it accepts rollovers. This allows you to consolidate your retirement savings in one place, simplifying oversight and management.
• Roll the funds into an Individual Retirement Account (IRA). An IRA is a personal retirement account that you open with a financial institution, which can provide you with a wider range of investment choices and more control.
• Cash out the account by taking a full distribution of the funds. This means you receive the entire vested balance in cash, removing it from its tax-advantaged retirement status. This action has significant tax implications and is generally considered a last resort.

Key Information for Your Decision

Before selecting an option, gather specific information. Your account balance is a primary factor, as it determines if you can leave funds in the old plan. If your balance is below the plan’s force-out threshold, which can be as high as $7,000, your options may be limited. You can find your vested balance on your most recent account statement.

Examine the fees associated with your old plan and compare them to a potential new plan or IRA. These fees, including administrative charges and investment expense ratios, are detailed in the Summary Plan Description (SPD). The SPD can be obtained from your former employer’s HR department or the plan administrator. Lower fees can substantially impact your long-term investment growth.

Compare the investment options available in each plan. Your old 401k has a specific menu of investments, and a new employer’s plan will have its own lineup. An IRA often offers a much broader universe of choices, including individual stocks, bonds, and exchange-traded funds (ETFs).

Executing a Rollover

A rollover is executed using two distinct methods, with the most common being a direct rollover. In this process, funds are transferred electronically from your old 401k administrator directly to the new 401k or IRA administrator. You must contact the new institution to open an account and complete their rollover paperwork to initiate the request. This method avoids tax complications because you never personally receive the money.

The alternative is an indirect rollover. In this process, the old plan administrator sends you a check for the proceeds but is required by the IRS to withhold 20% for federal income taxes. You then have 60 days from receiving the funds to deposit the full original amount into a new retirement account.

To complete the indirect rollover properly, you must use your own money to make up for the 20% that was withheld. For example, if your balance was $50,000, your old plan sends you a check for $40,000 and sends $10,000 to the IRS. You must deposit the full $50,000 into the new account within 60 days to avoid taxes and penalties. You can reclaim the withheld $10,000 when you file your annual tax return.

Tax Consequences of Cashing Out

Cashing out your 401k triggers immediate tax consequences. The entire amount of your distribution is considered ordinary income by the IRS. This means the total value is added to your other earnings for the year and is taxed at your marginal income tax rate. This can push you into a higher tax bracket, increasing your overall tax liability.

In addition to income tax, if you are under age 59½, the IRS generally imposes a 10% early withdrawal penalty on the distribution amount. This penalty is applied directly to the amount you withdraw. For instance, a $50,000 cash-out for a 40-year-old could result in a $5,000 penalty, in addition to the income taxes owed on that same $50,000.

When you request a cash distribution, your former plan administrator is required to withhold a flat 20% for federal taxes. This 20% is a prepayment toward your total tax bill. Your actual liability, which combines your marginal income tax rate and the 10% penalty, could be much higher, potentially amounting to 30%, 40%, or even more of the total distribution.

Handling Outstanding 401k Loans

If you have an outstanding 401k loan when you leave your job, you must address it promptly. Once you separate from the employer, the loan’s due date is accelerated. Under rules established by the Tax Cuts and Jobs Act of 2017, you generally have until the due date of your federal tax return for that year, including extensions, to repay the loan in full.

Failure to repay the outstanding loan balance by this deadline results in a loan default. When a 401k loan defaults, the IRS treats the entire unpaid balance as a taxable distribution from the plan. This means the defaulted amount is added to your taxable income.

The consequences of a loan default mirror those of a cash-out. The defaulted amount will be subject to ordinary income tax at your marginal rate. Furthermore, if you are under age 59½, the 10% early withdrawal penalty will also apply to the outstanding loan balance.