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

Why Deciding What to Do With an Old Retirement Plan Matters

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One of the more common questions that often arises when someone leaves their job is what should they do with their old retirement plan. This is a question that will continue to be asked as workers are increasingly likely to switch jobs on a regular basis.

A survey by Deloitte found that two-thirds of millennials plan to leave their company in five years or less. When you factor in the additional employees of all ages who may change jobs or lose them involuntarily, the result is numerous workers in this country who need to make a decision about what they're going to do with their soon-to-be ex-employer's retirement savings plan (e.g., 401(k), 457 or 403(b) plan).

If you are a job-changing employee and find yourself in this situation where you have to decide what to do with an old retirement plan, your options include the following:

  1. Leave your account where it is (Note: this is usually an option if your balance is above a certain level, typically $5,000)
  2. Roll the account balance directly into your new employer's plan (if they offer one and accept rollovers) or a new or existing IRA
  3. Make an indirect rollover to your retirement plan through your new employer (if provided) or an IRA
  4. Take a cash distribution

Not making the move the right way can cost you a big chunk of your savings.

Reasons to Consider Leaving Your Account Where It Is

Many companies allow you to keep your retirement savings in their plans after you leave your job. Since this first option requires no action, it is often chosen through doing nothing. But leaving your 401k where it’s at isn’t always a matter of procrastination because there are some valid reasons to consider leaving your retirement plan where it is.

Some of the benefits of keeping your retirement plan with your former employer include the following:

  • Separation of Service Rules: 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 59½.
  • Familiar Investment Options: If you like the investment options in your former employer’s retirement plan (or just aren’t sure what to do with it yet), you can stick with what is more familiar until you are ready to make an informed decision.
  • Lower Fees: Many employer-sponsored retirement plans offer participants access to institutional share class mutual funds and very low-cost index funds, especially those sponsored by large employers. Consider keeping your existing funds where they are at if you like the institutionally priced (i.e., lower-cost) or unique investment options in your old plan that you may not 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 to Avoid Taxes and Penalties 

You have the option to avoid paying taxes (and paying a 10 percent early withdrawal penalty) by completing a direct, or trustee-to-trustee, transfer from your old plan to your new employer's plan. The benefits of moving your old retirement account to your new employer’s plan include the previously mentioned benefits of keeping your account with the old plan. But it can be easy to pay less attention to your old retirement accounts over time since you are no longer able to make additional contributions once you have left employment. For simplicity, 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 permits participants to borrow from their plan assets at a very low rate of interest. If you roll your old plan into your new plan, you’ll have a bigger base of assets against which to borrow. (A common borrowing limit is 50% of your vested balance up to $50,000, but check with your plan administrator for the specifics of your plan.)

Here are a few important steps to take to successfully move assets to your new employer’s retirement plan:

Step 1: Determine if your new employer has a defined contribution plan, such as a 401(k) or 403(b), that allows rollovers from other plans. Spend some time evaluating the new plan's investment options to decide if you will be satisfied with them and they fit your investment style. If your new employer doesn't have a retirement plan or if the portfolio options really aren't that appealing, consider staying in your old employer's plan or setting 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 appropriate person in your company or HR department and request instructions for making a rollover contribution. If you make the decision to roll your account to an IRA, contact the IRA custodian to request specific instructions to make sure you don’t make any mistakes and create a taxable event. You may have to fill out paperwork to establish an Individual Retirement Account if you do not already have one established. (See What to Know Before You Start an IRA Rollover)

The instructions you receive should usually include the following type of information:

  • The name of the retirement plan or custodian — this is who the distribution will be payable to.
  • Your account number.
  • The mailing address for where to send the contribution — if you receive the distribution by check.
  • Wire transfer instructions — if the distribution can be made electronically.

If you require any assistance with your rollover contribution, your Human Resources department or IRA custodian can help you out.

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 to have the information you obtained in Step 2 ready to go. Just be sure to select “direct rollover” or “trustee-to-trustee transfer” as the type of distribution. Transfers can potentially take up to four to six weeks, but time frames vary and can potentially take a little longer depending on the administrator.

Direct transfers are the most convenient and easy option from the perspective of taxes and penalties. The alternative option, an indirect rollover, is not as simple or convenient.

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. However, as a result, you are now ultimately responsible for getting it to the right place. You will 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 subsequently owe income taxes on the amount you failed to roll over, and if you're under 59½, you will face an additional 10 percent penalty tax. Beginning in 2015, indirect rollovers are limited by the one-rollover-per-year rule.

No matter what your actual plans are for the money, your old employer is required to withhold 20 percent from your distribution for federal income tax purposes. To avoid being taxed and penalized on this 20 percent, you must be able to put together 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.

For example, let’s assume that 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 is required to withhold 20 percent, or $20,000, and to send you a check for the remaining $80,000. To avoid paying taxes and penalties on the $20,000 that is withheld, you have up to 60 days to roll over the full amount, i.e. $100,000. Since you only have a check for $80,000, you'll have to come up with the other $20,000 from someplace else. Regardless, you’ll have to wait until you file your income tax return to get all or a portion of this money back (depending on what other taxes you owe and amounts were withheld). Hopefully, you have $20,000 lying around to help with the transfer; otherwise, the amount you fail to roll over will be treated as a taxable distribution subject to penalties.

Taking the Cash Distribution May Be a Costly Decision

Avoiding cash distributions can save you in taxes and penalties. That is because any amount that you fail to roll over will be treated as a taxable distribution. As a result, it would then be subject to a 10 percent penalty if you are under age 59½. Since the taxable portion 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 decided not to roll over any portion of the $100,000 distribution, they would report $150,000 of taxable income for the year. This would move them from the 25 percent marginal tax bracket to the 28 percent marginal tax bracket. Additionally, they would have to report $10,000 in additional penalty tax if under age 59½.

Cash distributions should only be considered in extreme cases of financial hardship such as if you are facing foreclosure, eviction, or repossession. If you have to go this route then only take out funds needed to cover the hardship plus applicable taxes and penalties.

So, if you're considering moving on to a new job – or have already made the move – review all of your options to make an informed decisions about what to do with the retirement funds you left behind.