What Happens to a 401(k) After You Leave Your Job?

After you leave your job, there are several options for your 401(k). You may be able to leave your account where it is. Alternatively, you may roll over the money from the old 401(k) into a new account with your new employer, or roll it into an individual retirement account (IRA), but you must first see when you are eligible to participate in the new plan. You can also take some or all of the money out, but there are serious tax consequences to that.

Make sure to understand the particulars of the options available to you before deciding which route to take.

Leave It With Your Former Employer

If you have more than $5,000 invested in your 401(k), most plans allow you to leave it where it is after you separate from your employer. “If it is under $1,000, the company can force out the money by issuing you a check,” says Bonnie Yam, CFA, CFP, CLU, ChFC, RICP, EA, CVA, CEPA, Pension Maxima Investment Advisory Inc., White Plains, New York. “If it is between $1,000 and $5,000, the company must help you set up an IRA to host the money if they are forcing you out.”

If you have a substantial amount saved and like your plan portfolio, leaving your 401(k) with a previous employer may be a good idea. If you are likely to forget about the account or are not particularly impressed with the plan’s investment options or fees, consider some of your other options.

“When you leave your job and you have a 401(k) plan which is administered by your employer, you have the default option of doing nothing and continuing to manage the money as you had been doing previously,” says Steven Jon Kaplan, CEO, True Contrarian Investments LLC, Kearny, New Jersey. “However, this is usually not a good idea, because these plans have very limited choices as compared with the IRA offerings available with most brokers.”

Roll It Over to Your New Employer

If you’ve switched jobs, see if your new employer offers a 401(k) and when you are eligible to participate. Many employers require new employees to put in a certain number of days of service before they can enroll in a retirement savings plan.

Once you are enrolled in a plan with your new employer, it’s simple to roll over your old 401(k). You can elect to have the administrator of the old plan deposit the contents of your account directly into the new plan by simply filling out some paperwork. This is called a direct transfer, made from custodian to custodian, and it saves you any risk of owing taxes or missing a deadline.

Alternatively, you can elect to have the balance of your old account distributed to you in the form of a check. However, you must deposit the funds into your new 401(k) within 60 days to avoid paying income tax on the entire balance. Make sure your new 401(k) account is active and ready to receive contributions before you liquidate your old account.

“Consolidating old 401(k) accounts into a current employer’s 401(k) program makes sense if your current employer’s 401(k) is well structured and cost-effective, and it gives you one less thing to keep track of,” says Stephen J. Taddie, managing partner, Stellar Capital Management LLC, Phoenix, Arizona. “Keeping things simple for you now also makes things simple for your heirs should they need to step in to take care of your affairs later.”

One other point if you’re close to retirement age: Money in the 401(k) of your current employer is not subject to required minimum distributions (RMD). Money in other 401(k) plans and traditional IRAs is subject to RMDs.

Roll It Over into an IRA

If you’re not moving to a new employer, or your new employer doesn’t offer a retirement plan, you still have a good option. You can roll your old 401(k) into an IRA.

You’ll be opening the account on your own, through the financial institution of your choice. The possibilities are pretty much limitless. That is, you’re no longer restricted to the options made available by an employer.

“The biggest advantage of rolling a 401(k) into an IRA is the freedom to invest how you want, where you want, and in what you want,” says John J. Riley, AIF, founder and chief investment strategist for Cornerstone Investment Services LLC, Providence, Rhode Island. “There are few limits on an IRA rollover.”

“One item you might want to consider is that in some states, such as California, if you are in the middle of a lawsuit or think there is the potential for a future claim against you, you may want to leave your money in a 401(k) instead of rolling it into an IRA,” says financial advisor Jarrett B. Topel, CFP, Topel & DiStasi Wealth Management LLC, Berkeley, California. “There is more creditor protection in California with 401(k)s than there is with IRAs. In other words, it is harder for creditors/plaintiffs to get at the money in your 401(k) than it is to get at the money in your IRA.”

Take Distributions

You can begin taking qualified distributions from any 401(k), old or new, after age 59½. That is, you can start taking some money out without paying a 10% tax penalty for early withdrawal.

If you’re retiring, it might be the right time to start drawing on your savings for your monthly income.

If you have a traditional 401(k), you must pay income tax at your ordinary rate on any distributions you take. If you have a designated Roth account, any distributions you take after age 59½ are tax-free as long as you have held the account for at least five years. If you do not meet the five-year requirement, only the earnings portion of your distributions is subject to taxation.

If you retire before age 55 or switch jobs before age 59½, you may still take distributions from your 401(k). However, you will be required to pay a 10% penalty tax, in addition to income tax, on the taxable portion of your distribution, which may be all of it. The 10% penalty does not apply to those who retire after age 55 but before age 59½.

Once you reach age 72, you are required to begin taking required minimum distributions from your 401(k). Your RMD amount is dictated by your expected life span and your account balance. The IRS has a handy worksheet to help you calculate the amount you must withdraw.

Cash It Out

Of course, you can just take the cash and run. While there is nothing stopping you from liquidating an old 401(k) and taking a lump-sum distribution, most financial advisors caution strongly against it. It reduces your retirement savings unnecessarily, and on top of that, you will be taxed on the entire amount.

If you have a large sum in an old account, the tax burden of a full withdrawal may not be worth the windfall. Plus, you’ll probably be subject to the 10% early withdrawal penalty.

“Other than having to pay regular income taxes and a tax penalty of 10% before age 55 (not small considerations), few people consider the time value of (in this case, tax-deferred) money already saved,” says Jane B. Nowak, CFP, Southbridge Advisors, Atlanta, Georgia. “By taking a full withdrawal, they’re creating the need ‘to start all over’ saving for retirement. Generally, it’s a much better idea to leave the money to grow tax-deferred in a retirement account and not take a withdrawal.”

The Bottom Line

Perhaps Riley sums up best what you might want to do with the money in a former employer’s 401(k) plan: “One really has to look at all the pros and cons before deciding what to do with 401(k) money.”