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

When you change jobs, one important decision involves what to do with your 401(k) retirement savings. Your 401(k) account is linked to your employment, meaning that upon departure from a company, you must decide the future of these funds. Understanding the available choices is an important step in managing your retirement savings effectively.

Understanding Your Account and Vesting

When evaluating your 401(k) balance after leaving a job, understanding vesting is important. Vesting refers to the ownership you have over contributions made to your retirement account, particularly those made by your employer. While your own 401(k) contributions are always immediately 100% vested, employer contributions may be subject to a vesting schedule.

Two common types of vesting schedules are cliff vesting and graded vesting. Cliff vesting grants 100% ownership of employer contributions all at once after a specified period, typically up to three years of service. Graded vesting allows you to gradually gain ownership of employer contributions over time, with a percentage vesting each year until you reach 100% ownership, usually over a period not exceeding six years. To determine your vested balance, review your plan statements or contact your former employer’s human resources department or the plan administrator. Knowing this exact amount is crucial for making informed decisions about your funds.

Considering Your Distribution Options

After separating from your employer, you have several options for managing your 401(k) funds. One choice is to leave your funds in the old employer’s plan, provided the plan rules allow it and your balance exceeds a certain threshold, often $5,000. If your vested balance is below this amount, your former employer may force out your funds, either by issuing a check or initiating a rollover to an Individual Retirement Account (IRA). While no new contributions can be made, your investments continue within the plan’s existing options.

Another common pathway is rolling over your funds to a new employer’s 401(k) plan. This option allows you to consolidate your retirement savings if your new plan accepts such rollovers, maintaining the tax-deferred status of your funds within an employer-sponsored plan.

You can also roll over your 401(k) to an IRA, which provides broader investment choices and simplifies management by consolidating various retirement accounts. This can be a rollover to a Traditional IRA, maintaining tax-deferred growth, or a conversion to a Roth IRA, where future qualified withdrawals are tax-free. Transfers to an IRA can be either direct or indirect.

Finally, you can take a cash distribution, receiving a lump sum payout of your vested 401(k) balance. This provides immediate access to your funds but comes with significant tax implications and potential penalties.

Tax Consequences of Distribution Choices

Your 401(k) distribution decision significantly impacts your tax obligations. A direct rollover of funds, either to a new employer’s 401(k) or an IRA, is generally tax-free. This means no immediate income taxes or penalties are incurred, as the funds remain within the qualified retirement system.

An indirect rollover, where you receive a check and then deposit funds into a new qualified account, is subject to the 60-day rollover rule. If the full amount is not deposited within 60 days, the distribution may be treated as taxable income and incur penalties. For indirect 401(k) rollovers, the plan administrator generally withholds 20% for federal income tax. If you complete the rollover within the 60-day window, including the withheld amount, this 20% is credited back when you file your tax return.

Taking a cash distribution has immediate tax consequences. The entire distributed amount is typically taxed as ordinary income in the year it is received. Additionally, if you are under age 59½ at the time of withdrawal, a 10% early withdrawal penalty usually applies to the taxable portion of the distribution. However, several exceptions can waive this penalty. These include separation from service at or after age 55, distributions due to total and permanent disability, or withdrawals for qualified higher education expenses. State income taxes may also apply.

Steps for Fund Rollovers and Withdrawals

Once you determine the best course of action for your 401(k), initiating the process involves several practical steps. For any distribution or rollover, contact your former employer’s 401(k) plan administrator or the plan’s recordkeeper. This entity provides the necessary forms and specific instructions tailored to your plan.

For a direct rollover, which is generally the preferred method, the plan administrator directly transfers your funds from your old 401(k) to your new employer’s plan or chosen IRA custodian. This transfer avoids the 20% mandatory federal income tax withholding and the 60-day rollover deadline. The process typically takes a few weeks, varying based on the efficiency of the involved institutions.

If you opt for an indirect rollover, the plan administrator will issue a check or direct deposit of your funds, minus the mandatory 20% federal tax withholding. You have 60 days from receipt to deposit the full amount, including the withheld portion, into a new qualified retirement account. Failing to meet this deadline results in the distribution being considered taxable income, subject to penalties.

To initiate a cash distribution, complete specific forms provided by the plan administrator, indicating your election for a direct payout. You may specify federal and state tax withholding elections on these forms. After the transaction, typically within a few weeks, you will receive a Form 1099-R from the plan custodian by January 31 of the following year. This form reports the distribution amount and any taxes withheld, which you will need for filing your income tax return.