What Are Your 401K Options When You Change Jobs?
by John Cooney on Mar 23, 2017
You Switched Jobs, Now What Should You Do With Your Old 401K?
If you have not already, chances are you will switch employers at some time in your career. The Department of Labor released a report on job tenure in 2016 that showed the average number of years employees had been in their current job was 4.2 years. Lest you think this is only driven by young workers, the study showed that even for workers between the ages of 55 – 64, the average tenure was just 10.1 years. All of this means, that more than likely, you will switch employers at least twice during your work career. A question that often comes up when switching employers is what to do with your 401K. It is an important question to ask, and you need to make sure you do your homework to avoid paying costly fees and penalties that can eat away at your retirement funds. In general, an employee who leaves their employer has four options on how to handle their 401K; do nothing, cash out the account, rollover the account into your new employer’s 401K, and rollover the 401K into an IRA.
Understand first, if your account balance is below $5000, your options are somewhat limited. If you have less than $1000 in your 401K account, the employer is allowed to cash out the plan and send you a check. This could be treated as a taxable event for you if the proceeds are not deposited into another 401K or an IRA account within 60 days. In general, if you have more than $5000 in the account, the plan administrator must get your consent before making a distribution. If the account balance is more than $1000 and you have not elected to receive the disbursement directly or directed the plan to be rolled over to an eligible retirement plan, the plan administrator is required to transfer the distribution directly to an individual retirement plan or issuer and must notify you in writing that the distribution may be transferred to another individual retirement plan. What does all this mean? If you have less than $1000, expect the administrator to cash out the plan and send you a check. If you have more than $1000 and less than $5000, the administrator will generally transfer to another retirement plan and notify you that you can then transfer to a retirement plan of your choice. If you have over $5000, the plan administrator cannot do anything with your money without your consent.
Keep in mind when reading through the below options, that most plans will allow for a full or partial rollover, so you do not always have to transfer all of the funds into a new account. A partial withdrawal can help diversify your retirement accounts if the accounts available themselves are significantly different from each other. This can be particularly important if your 401K plan has a large percentage of employer stock in it. That is because of a rule, Net Unrealized Appreciation (NUA), which allows a plan participant to treat the gains in employee stock held in a 401K as capital gains versus income, potentially saving them large sums in taxes. To take advantage of this situation, you cannot rollover the stock from the 401K plan, but you can do a partial rollover to move the non-company stock to a new account and leaving the company stock in the original account. If you think this situation could apply to you, I highly recommend talking to a Financial Planner to ensure it is handled in a manner that minimizes your exposure to taxes.
Now that we have gone over some of the basic rules, let’s talk options. Your first option is to do nothing. You can leave the money in your former employers plan, but you will no longer be able to contribute to the plan. Why would you want to do this? Well, there could be a variety of reasons. Maybe you like the investment options available to you in the plan and these options are not available to you at your new place of employment. Fees are another reason. Different plans charge different fees to maintain the investment accounts. If your current account fees are low and you like the investment options then you may decide you would rather leave your 401K where it is than roll it to a new account. Another reason could depend on the rules of your individual plan. Some 401Ks will allow for loans out of the plan. While 401Ks are not normally your best option to choose as a loan source, having that option may give you some flexibility and stand as a reason for leaving the money in the plan. Loans are not available out of an IRA account, and may not be available in your new employers 401K. Additionally, if you separated from service during or after the year in which you turned 55, you can begin distributions without incurring the 10% early withdrawal penalty from a 401K.
Rollover to Your New 401K
If your new employer offers a 401K plan and accepts rollovers, your second option is to direct a rollover from your former 401K into your new 401K. One of the main reason employees like to do this is for the simplicity of having one account to look after. Beyond simplicity there are other reasons as well; you may like the investment choices your new employer offers and or the fees charged may be lower in the new plans. Additionally, some of the same benefits available to you by leaving the money in your old 401K will exist in your new one as well. Most notably, the ability to take out a loan against your 401K balance, an option not available if the funds are in an IRA, and beginning withdrawals at 55 without incurring the 10% early withdrawal penalty if you separated from service during or after the year in which you turned 55. To complete a rollover to your new employer’s 401K plan it is best to contact your human resources department and let them tell you what paperwork you will need to fill out to direct the rollover. It is important to have the rollover done directly from financial institution to financial institution. If it is done this way, no taxable event occurs. If your former plan distributes the money to you directly, by law, they are required to withhold 20% of the amount for taxes. You would then have 60 days to deposit the full amount (the 80% they distributed and the additional 20% they did not distribute) into another retirement account. If you do not, the distribution will be treated as income for tax purposes, and if you are under 59 ½, you would owe an additional 10% early withdrawal penalty. You are best off avoiding this altogether, if you aren’t sure what account you want it transferred to, leave it in the present account until you decide.
Rollover to an IRA
What if you don’t like your former plan or your new employer’s plan? Well, a third option available to you is to rollover the funds from your account in your former employer’s 401K plan to an IRA plan of your choosing. There are a couple reasons you may want to go this route. First, your may be going into a job that does not offer a retirement plan or offers one that does not accept rollovers. You may not like the investment choices that are in your old plan or available with your new employer. If you choose to rollover to an IRA, you can choose from a much larger selection of funds to invest in, giving you more freedom to select where your money is invested. There are three very important considerations to have in mind when choosing to rollover to an IRA. First, make sure the rollover is done from the former financial institution to the new financial institution, without using yourself as an intermediary. If the distribution is made directly to you, you will be subject to penalties and taxes based on your age if the full distribution amount is not deposited into a new retirement account within 60 days. Secondly, make sure you understand the fees associated with the accounts you are investing in. You should always select funds based on expected performance, not fees, but it is important to know what those fees are as they can impact your bottom line. Third, when rolling over to an IRA, you can choose a traditional IRA or a Roth IRA. If you choose the traditional, you will pay taxes when you withdraw the money in retirement. If you choose Roth, you will pay taxes at the time of the rollover, but the earnings will be tax free in retirement.
Take a Cash Disbursement
Of course, assuming you are fully vested in your company’s 401K plan you can always take a cash disbursement from your plan. I am listing this option last, and I hope that you consider it last as well. The money you invest in a 401K plan comes with many tax benefits; most notably pre-tax contributions and tax-deferred growth. These benefits were put in place to encourage employees to plan for retirement. In the spirit of retirement planning, the government also put in penalties to discourage employees from taking distributions from their account prior to reaching 59 ½. If you direct your former plan administrator to disburse the funds to yourself, the IRS mandates that the financial institution withhold 20% for taxes. That means if you have $100,000 in your 401K and request a full distribution, you would only receive $80,000. The 20% withholding is to ensure when it comes time to pay taxes, the IRS is ensured that they get at least 20% of the distribution. This does not mean that the 20% will be enough to pay your tax bill when it comes due, depending on your total income, you may owe more than what was withheld. Additionally, if you are under 59 ½, the IRS imposes a separate 10% penalty tax on the amount includible in your gross income. Beyond just the financial penalties with the disbursement, you could also be doing serious damage to your ability to fund your lifestyle in retirement. I hope this illustrates why cashing out should be your last option. Now, the IRS is not completely heartless, they do have exceptions to paying the 10% penalty (but not for the withholding or income tax). You can find the exceptions listed here. (https://www.irs.gov/taxtopics/tc558.html).
There are a lot of questions that can come up when determining what to do with your 401K when you switch jobs. I have listed a few websites below that you can use as guides, but if you have specific questions on your situation you should have a financial planner assist you. Even if you have not switched jobs, you may have question on whether or not you are doing the right things for retirement. Contact us today at email@example.com for a no-obligation introductory call and see if we can help you feel secure about your financial future.
What’s worrying you financially? What topics would you like us to discuss here? Follow Green and Gold Financial Planning on Linked In at https://www.linkedin.com/company/11059847 and on Twitter @greenandgoldfp and let us know what you’d like to see.