Leaving Your Employer? Here’s what you can do with your 401(k)

Leaving Your Employer? Here’s what you can do with your 401(k)

Jake Skelhorn
February 13, 2024

Whether you have retired, been laid off, or just left your job for a better opportunity, your former employer’s 401(k) plan allows for a few options that should be carefully considered before making a knee-jerk decision. Your choice can have a significant long-term effect on your retirement and tax liability.

Before we get into the options, here are a few things to remember:

  • A 401(k) is a retirement plan. As such, if you are younger than 59 ½ , the IRS will ding you an extra 10% for withdrawing your funds early, with some exceptions.
  • In most cases, you don’t need to act fast. Just because you are no longer an employee doesn’t mean you must make a decision immediately.
  • Employer-sponsored retirement plans come with excellent tax advantages, but they also have rules you must follow – and the rules vary by employer. Ultimately your summary plan description will govern what you can and can’t do while your money remains in the 401(k). Check with your plan’s administrator for the final answer to any questions you may have.

The Options

Do Nothing

That’s right. If your vested balance is over $5,000, excluding any money you may have rolled over into the 401(k) from a previous job, you can usually keep your funds in your former employer’s 401(k). As stated above, there are stipulations in doing so. In my experience, the most significant is that your 401(k) plan may not allow partial withdrawals. This can be a problem if you need some cash for bills while searching for a new job or if you’re a retiree who needs a steady income stream. There could also be plan recordkeeping fees that you pay to stay put. These fees are usually minimal for larger employers, whereas smaller employers can have high costs for recordkeeping and investment expenses. This option is not all bad, though. 401(k)s allow your investments to grow tax-deferred or tax-free if you contribute to a Roth 401(k). If in doubt, keep your money where it’s at while you make an informed choice.

Lump Sum Withdrawal

This should be a last-resort option. Withdrawing your entire balance immediately, if pre-tax, will create additional income and could put you into a higher tax bracket. While it might be tempting to get your hands on cash, a lump sum withdrawal also takes away the ability for your funds to continue compounding over the years between now and retirement. For example, let’s say you have $50,000 in your 401(k) when you leave your employer. Assuming it is invested in a broad market index fund earning 8% per year over the next 30 years, that $50,000 would be worth a little over $500,000 – without adding a penny! If you’re early in your career, try to avoid this option. If you’re closer to retirement, a lump sum withdrawal still has downsides beyond tax consequences. Since a withdrawal from a 401(k) is considered ordinary income, it can affect Social Security and Medicare benefits (spoiler, not in a good way).

Rollover to Another Qualified Employer Plan

A rollover refers to transferring your balance to another retirement account, which can be an employer-sponsored plan or an IRA, which will be discussed next. Rolling over to your current employer’s plan can be a good option for several reasons. For one, it’s a non-taxable event. Don’t be alarmed when you get a 1099 form; Uncle Sam still wants to know where the money is going, even if he’s not taxing it yet. Second, one of the benefits of a 401(k) is the ability to take a loan against it. While a loan should be a last resort since it takes your money out of the market, rolling your balance to your new 401(k) can give you an instant balance to take a loan from if your plan allows. In some states, 401(k) plans are protected from creditors to a greater extent than assets held in IRAs or other types of investment accounts. However, when rolling your old 401(k) to your new one, you subject your money to that plan’s rules and typically cannot move that balance until you leave that employer. Before rolling to your new plan, I highly recommend doing your due diligence on the investment choices and associated expenses.

Rollover to a Traditional IRA or “Rollover IRA”

Rolling over to an Individual Retirement Account is popular for job changers and retirees. With an IRA, you are no longer subject to your former employer’s rules, which means more withdrawal flexibility, more investment choices, and the ability to make contributions (contributions cannot be made to a former employer’s 401(k)). IRAs are popular for those who want professional advice and guidance on investing and planning for their retirement since 401(k) plans are generally DIY. IRA rollovers are not without drawbacks, though. Moving pre-tax assets to a Traditional IRA limits the effectiveness of the backdoor Roth IRA strategy, which contributes to a Roth IRA for high earners who are above the income limit to make direct contributions. And since 401(k) plans typically offer special share classes of mutual funds that have low expenses, similar investments in IRAs can be higher cost. With that said, I hardly see this as an issue anymore with the availability of ultra-low-cost ETFs. IRAs offer more control over your money with the same tax benefits as 401(k)s.

*Bonus Option- Convert to a Roth IRA

A Roth conversion involves transferring pre-tax money to an after-tax retirement account (Roth IRA or 401(k)). Because Roth conversions involve tax consequences, they only make sense in specific scenarios. One such scenario could be that you are taking an extended period of time off of work, thus reducing your income to a much lower tax bracket. The goal is to convert to Roth at a lower tax bracket than your expected future tax bracket to reduce your overall tax liability. Note that any earnings on Roth conversions must remain in the Roth IRA for five years, and the account owner must be 59 ½ to withdraw tax and penalty-free. Roth IRAs also do not have required minimum distributions in later years like Traditional IRAs and other pre-tax retirement plans. This can be a significant factor for retirees aiming to keep their taxable income low in retirement to maximize certain income-based benefits like Medicare. A Roth conversion is not to be confused with a Roth rollover; simply transferring your Roth 401(k) balance to a Roth IRA is non-taxable. If done correctly, Roth conversions can be complex but can offer significant overall tax savings later in life.

So, leave it, cash it, or roll it? There’s no one-size-fits-all answer, as you may have guessed. Suppose you are between jobs and need money for bills. Use your emergency savings for immediate expenses before accessing your taxable 401(k) funds via the lump sum option. Remember, there are no deadlines (typically) for deciding, so keeping your money in your former employer’s plan is okay while you evaluate your rollover options. An IRA is a viable option if you are seeking more control over your money or the ability to let someone else manage it for you.