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

A 401(k) plan is a tax-advantaged retirement savings vehicle offered by employers, allowing individuals to contribute a portion of their salary. Contributions, often complemented by employer matching funds, grow on a tax-deferred basis, with taxes typically paid only upon withdrawal in retirement. When transitioning between jobs, individuals face decisions regarding their accumulated 401(k) savings. Understanding the available choices is important for financial security. Each option carries distinct implications for accessibility, investment flexibility, and tax treatment, requiring careful consideration.

Leaving Your 401(k) with Your Former Employer

One option upon leaving a job is to keep your 401(k) assets within your former employer’s plan. This choice is available if your account balance meets a threshold, often $7,000 or more. If your balance is between $1,000 and $7,000, your former employer might automatically transfer your funds to an Individual Retirement Account (IRA). Should your balance be less than $1,000, the employer may cash out the account and send you a check, triggering immediate tax consequences.

You lose the ability to make new contributions to that specific account. Investment choices may be more limited compared to an IRA, and administrative fees could be higher, potentially ranging from 0.2% to 5% of assets annually or specific recordkeeping fees between $45 and $80 per participant. Managing multiple old 401(k) accounts from different employers can also become cumbersome, making it difficult to consolidate your retirement assets or track required minimum distributions later in life.

Rolling Over Your 401(k)

Rolling over your 401(k) involves transferring funds from your old employer’s plan into another qualified retirement account. There are two primary methods for executing a rollover: a direct rollover or an indirect rollover.

A direct rollover, also known as a trustee-to-trustee transfer, is generally the preferred method because it moves funds directly from your old plan administrator to the new account custodian. This process avoids any mandatory tax withholding and potential penalties. The funds can be transferred to a new employer’s 401(k) plan, if that plan permits such rollovers, or into a Traditional Individual Retirement Account (IRA). You can also roll funds into a Roth IRA, though this is considered a “Roth conversion” and has unique tax implications.

You will need contact details for your former employer’s 401(k) plan administrator and, if applicable, your new employer’s plan administrator. If rolling into an IRA, you will need information from your chosen IRA custodian, such as a bank or brokerage firm. Account numbers and other identifying details for both the old 401(k) and the new destination account are necessary.

Your old 401(k) plan will likely require specific forms for distribution or rollover requests. When completing these forms, you must clearly specify that you intend a direct rollover to ensure the funds are sent directly to the new custodian. The old plan administrator may send a check made payable directly to your new IRA custodian or new 401(k) plan, or they may process an electronic transfer. Some plans may require a “letter of acceptance” from the receiving institution to confirm they will accept the assets.

An indirect rollover involves the plan administrator issuing a check directly to you, the participant. If you choose this method, you must deposit the full amount into a new retirement account within 60 days to avoid taxation and potential penalties. A significant aspect of an indirect rollover is the mandatory 20% federal income tax withholding from the distributed amount, even if you intend to complete the rollover. This means you will only receive 80% of your funds initially, and if you wish to roll over the entire original amount, you must use other funds to cover the 20% that was withheld. If the 60-day deadline is missed, the entire distribution becomes taxable as ordinary income, and if you are under age 59½, an additional 10% early withdrawal penalty may apply.

Rolling funds from a pre-tax 401(k) into a Roth IRA is a taxable event. The entire amount converted is considered taxable income in the year of conversion and will be taxed at your ordinary income tax rate. While this incurs an immediate tax liability, it allows future qualified withdrawals from the Roth IRA to be tax-free in retirement.

Cashing Out Your 401(k)

Cashing out your 401(k) means taking a lump sum distribution directly to yourself without rolling it over into another qualified retirement account. While this provides immediate access to the funds, it carries significant financial consequences. The entire distribution is taxed as ordinary income in the year you receive it. This means the amount withdrawn is added to your other income for the year and taxed at your marginal income tax rate.

Additionally, if you are under age 59½, you will incur an extra 10% early withdrawal penalty on the distributed amount. Exceptions to this penalty include:
Separation from service at or after age 55
Total and permanent disability
Certain unreimbursed medical expenses
Substantially equal periodic payments
Qualified birth or adoption expenses up to $5,000 per child
Distributions due to a federally declared disaster

Even if an exception applies, the distribution is still subject to ordinary income taxes.

When you cash out, your plan administrator is required to withhold 20% of the distribution for federal income tax. This mandatory withholding is sent to the IRS as a prepayment of taxes, but it may not cover your full tax liability, especially if you are in a higher tax bracket. You may also owe state income taxes, depending on your state of residence.

Beyond the immediate taxes and penalties, cashing out your 401(k) can have a substantial long-term impact on your retirement savings. You lose the benefit of compounded growth over many years, which can significantly diminish your potential nest egg. The procedural step for cashing out is straightforward, involving a request for a distribution form from your plan administrator and specifying direct payment to yourself.