Are you one of the millions of Americans who contribute a portion of your salary each pay period to a 401k retirement savings plan? Unlike an Individual Retirement Account (IRA), 401ks are sponsored by employers. So this brings up the question: What happens to your 401k when you quit or leave your job?
The average American will hold 10 different jobs before reaching the age of 40, according to the Bureau of Labor Statistics. If the average person participates in a 401k plan at just a few of the jobs where they work, then they’ll have to decide what to do with the 401k assets held in accounts each time they leave one job to start a new one.
With all the news lately around “the great resignation,” with more and more workers opting to walk away from their jobs after a year of working from home, it’ll be important for people considering this to know what to do with their 401k plans.
What Happens to Your 401k When You Leave a Job?
Unfortunately, many people choose not to make a decision about what to do with their 401k funds. Instead, they simply leave the funds behind in their former employer’s 401k plan. Most plans allow former employees to leave funds in their account if the account contains more than $5,000. If there’s less than $5,000 in the account, the plan sponsor may issue the former employee a check in order to close out the account.
While leaving money behind in a former employer’s 401k might be the easiest thing to do, it’s not always the best option. People often fail to monitor accounts held at former employers as closely as they should — the money becomes “out of sight, out of mind.” This problem can worsen if an individual ends up leaving money behind in several different former employers’ 401ks.
Also, the main benefit of a 401k plan is an employer match if the company offers one. Once you leave a job where you have a 401k, you no longer receive the match. And there are better investment vehicles out there – 401k plans tend to have high fees, limited investment options, and strict withdrawal rules. So if you’re no longer receiving the match, it’s usually best not to leave your assets languishing in an old 401k.
Other Options to Consider
There are several options available to you other than just leaving 401k funds behind in your former employer’s plan, including the following:
Rollover the money into your new employer’s 401k plan.
If your new employer offers a 401k plan with low costs and a wide variety of investment options, this might be a viable option to consider. However, we generally recommend that people rollover their 401k plans into an IRA as they are usually lower cost and have more investment options, but more on that later.
If you are interested in rolling the money over into your new employer’s 401k, meet with the HR department or retirement plan custodian to find out more about your new company’s plan, including whether you will be allowed to participate as soon as you’re hired or will have to work for a certain number of days before you’re eligible.
To accomplish this rollover, you will instruct the administrator of your former employer’s 401k to transfer your assets directly into your new employer’s plan once your account has been established. Alternatively, you can instruct the former employer’s 401k administrator to send you a check — but you must deposit the funds into your new account within 60 days to avoid paying income taxes and a potential penalty on distribution.
Rollover your old 401k money into a new IRA.
Known as a rollover IRA, this type of IRA is designed to accept the transfer of assets from a former employer’s 401k. If your new employer doesn’t offer a 401k or you’re not pleased with the plan’s costs or investment options, this is probably your best option because it will give you the most flexibility and control to stay on track with your retirement savings goals. In fact, this is what we generally recommend to our clients who have old 401ks. IRAs generally have more investment options, no plan fees, and greater withdrawal flexibility.
In order to execute a rollover IRA, your first step is to open a new IRA with an investment advisor or financial institution. The rollover process is similar to the one described above except that you will instruct the administrator of your former employer’s 401k to transfer plan assets directly into your new rollover IRA.
Conversely, you can have a check sent directly to you, but make sure that the check is made payable to your IRA custodian for benefit of (FBO) your name. The former plan administrator will withhold 20% of the amount for the payment of taxes and you will have 60 days to deposit the full balance, including the 20% withheld, into your rollover IRA. Failure to deposit the entire amount into your new IRA could result in current tax liabilities plus a 10 percent penalty if you’re under age 59½.
Take a lump-sum distribution.
You can also choose to simply cash out the account by receiving a lump-sum distribution of the money in your former employer’s 401k. However, you should be aware that you’re not going to receive the full balance in your account because you will have to pay not only income taxes, but also a 10% penalty if you are under a certain age. In fact, taxes and penalties could consume up to half of the account’s value, depending on your tax bracket.
This is one reason why we almost always advise against taking a lump-sum distribution from a former employer’s 401k plan. This strategy could also jeopardize your retirement financial security by diverting funds from retirement savings where they could continue growing on a tax-deferred basis.
Start making qualified distributions.
If you meet the age requirement, you can begin making qualified distributions from your former employer’s 401k plan. While you won’t be assessed a 10% penalty on these distributions, you will have to pay income taxes at your current ordinary income tax rate if the distributions are made from a traditional 401k.
Our Take: Start Planning Now
If you have an old 401k plan or are about to leave a job where you contributed to a 401k, give some thought now to how you will handle the money in your account. A rollover IRA is the best option for most people, but a financial advisor can help you determine what’s right for your specific situation.