Think Twice Before Deciding What to Do With an Old 401k

What to Do With Your Old 401(k) When You Quit and Why It Matters

Woman with 401(k) jar
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Getty Images/JGI/Jamie Grill 

One common question when leaving a job is what to do with the old retirement plan. Whether you leave involuntarily, quit to start a new job, or see yourself switching jobs several times in the next few years, you need a plan for your (soon-to-be) former employer's retirement savings plan. That's your 401(k), 457 or 403(b).

One wrong move can cost a big chunk of your savings, so you need to be ready to take the right steps.

What You Can Do With Your Old 401(k) When You Leave

If you are a job-changing employee and must decide what to do with an old retirement plan, you can leave the account where it is, roll the balance directly into a new or existing IRA or your new employer's plan, make an indirect rollover, or take a cash distribution.

Leave Your Account Where It Is

Many companies allow you to keep your 401(k) savings in their plans after you leave your job. Often that's only if you meet a minimum balance requirement, typically $5,000. Since this option requires no action, it is often chosen by default. But leaving your 401(k) where it is isn’t always a result of procrastination. There are some valid reasons to do it.

You can take penalty-free withdrawals from an employer-sponsored retirement plan if you leave your job in or after the year you reached age 55 and expect to start taking withdrawals before turning 59 1/2.

Other reasons you may want to keep your retirement plan where it is include:

Familiar Investment Options 

You may like the options in your former employer's retirement plan, or perhaps you aren't yet sure what to do with the money. Don't rush. You can stick with the familiar investments until you are ready to make an informed decision.

Unique Investments and Lower Fees 

Many employer-sponsored retirement plans give you access to institutional share class mutual funds and low-cost index funds, especially at large employers. You may like certain lower-cost or unique investment options in your old plan that you won't be able to roll into or hold in an IRA.

Professional Guidance

Many retirement plans offer specialized money-management services with competitive fees that you may wish to maintain.

Protection Against Lawsuits

Employer-sponsored retirement plans provide broader creditor protection under federal law than is provided with an IRA.

Move Your Old 401(K) Assets Into a New Employer’s Plan  

You have the option to avoid paying taxes (including a 10% early-withdrawal penalty tax) by completing a direct, or "trustee-to-trustee," transfer from your old plan to your new employer's plan, if the employer's plan allows it.

It can be easy to pay less attention to your old retirement accounts, since you can no longer contribute. So, transferring old 401(k) assets to your new plan could make it easier to track your retirement savings. 

You also have borrowing power if your new retirement plan lets participants borrow from their plan assets. The interest rate is often low. You may even repay the interest to yourself. If you roll your old plan into your new plan, you’ll have a bigger base of assets against which to borrow. One common borrowing limit is 50% of your vested balance, up to $50,000. Each plan sets its own rules.

Here are a few important steps to take to successfully move assets to your new employer’s retirement plan so as not to trigger a tax penalty:

Step 1: Find out whether your new employer has a defined contribution plan, such as a 401(k) or 403(b), that allows rollovers from other plans. Evaluate the new plan's investment options to see whether they fit your investment style. If your new employer doesn't have a retirement plan, or if the portfolio options aren't appealing, consider staying in your old employer's plan. You could also set up a new rollover IRA at a credit union, bank, or brokerage firm of your choice.

Step 2: If you decide that rolling your old retirement account into your new employer’s plan makes sense, contact the right person in your company, and ask how to make a rollover contribution.

If you decide to roll your account into an IRA, contact the IRA custodian to request specific instructions. You don’t want to make any mistakes that would create a taxable event. You may have to fill out paperwork to establish an IRA if you do not already have one.

The instructions you get should ask for this type of information:

  • The name of the retirement plan or custodian—the distribution payee
  • Your account number
  • The mailing address to send the money—if you receive the distribution by check
  • Wire-transfer instructions—if the distribution can be made electronically

If you need help with the rollover, your human resources department or IRA custodian can assist.

Step 3: The next move is to contact your former employer’s HR department or 401(k) administrator to request a distribution. You will need the information you obtained in Step 2. Just be sure to select “direct rollover” or “trustee-to-trustee transfer” as the type of distribution.

A direct transfer is the simple option in terms of taxes and penalties. The alternative, an indirect rollover, is not as convenient. Still, direct transfers can take up to six weeks, so be patient. It all depends on how quickly your current plan administrator responds to the request.

If you haven’t heard anything back after six weeks, don’t be afraid to follow up in case the paperwork went missing or your rollover hit another snag.

Indirect Rollovers Can Be Complicated to Manage

With an indirect rollover, you receive a check for the balance of your account that is made payable to you. That might sound good, but as a result, you are now responsible for getting it to the right place. You have 60 days to complete the rollover process of moving these assets to your new employer's plan or an IRA.

If you don’t complete the rollover within this 60-day window, you will owe income taxes on the amount you failed to roll over. If you're under 59 1/2, you will also face a 10% penalty tax. Indirect rollovers can be made once a year.

Your old employer is required to withhold 20% from your distribution for federal income tax purposes. To avoid being taxed and penalized on this 20%, you must be able to get enough money from other sources to cover this amount and include it with your rollover contribution.

Then, you’ll have to wait until the following year, when you can file your income tax return to actually get the withheld amount back.

Suppose the 401(k) or 403(b) from your prior employer has a balance of $100,000. If you decide to take a full distribution from that account, your prior employer must withhold 20%. That means they keep $20,000 and send you a check for the remaining $80,000.

You have up to 60 days to roll over the full amount of $100,000 without incurring taxes or penalties. Since you only have a check for $80,000, you must come up with the other $20,000 yourself. If you can't, the amount you fail to roll over will be treated as a distribution subject to taxes and a 10% early withdrawal penalty if you are under age 59 1/2.

Even if you have an extra $20,000 on hand, you still must wait until you file your income tax return to get the withheld $20,000 returned—or a portion of it, depending on what other taxes you owe and any other amounts withheld.

Taking the Cash Distribution May Cost You

Avoiding cash distributions can save you from taxes and penalties, because any amount you fail to roll over will be treated as a taxable distribution. As a result, it would also be subject to the 10% penalty if you are under age 59 1/2.

Since the taxable portion of a distribution will be added to any other taxable income you have during the year, you could move into a higher tax bracket.

Using the previous example, if a single taxpayer with $50,000 of taxable income were to decide not to roll over any portion of the $100,000 distribution, they would report $150,000 of taxable income for the year. That would put them in a higher tax bracket. They also would have to report $10,000 in additional penalty tax, if they were under the age of 59 1/2.

Only use cash distributions as a last resort. That means extreme cases of financial hardship. These hardships may include facing foreclosure, eviction, or repossession. If you have to go this route, only take out funds needed to cover the hardship, plus any taxes and penalties you will owe.

The CARES Act, enacted on March 27, 2020, provided some relief for those who need to make withdrawals from a retirement plan. It lifted penalties for withdrawals made through December 2020 and provides three years to pay back any early withdrawals.