You left your company. Maybe you decided to quit, retire early, or maybe you got fired. Now what do you do with your 401(k) plan? For the most part, the treatment is governed by your 401(k) plan rules to some extent, and also by IRS regulations. But you do have some options. Let’s take a look at what the most common options are for people leaving a company with a 401(k) plan.
If your plan permits, the easiest approach is to leave your plan in place. That is, leave it with your employer’s administrator. Generally, this is the default option. However, many plans have a vested balance requirement guided by IRS regulations. Usually, this is an account balance requirement of $5,000 or more. This is because the IRS allows 401(k) plans to “cash out” small balances (that the IRS defines as $5,000 or less). These rules also require a rollover option if the balance is between $1,000 and $5,000. Under $1,000, if you don’t make a decision, your employer’s plan administrator will likely send you a check if you don’t make a decision within a certain amount of time. Even though this is a small amount, cashing out can hurt you if you are under age 59 ½ because of the 10% penalty in addition to the ordinary income tax due.
Leaving your balance, if large enough, with your previous employer does allow for the balance to continue to grow. It also keeps your savings growing tax-deferred. One final benefit, is that balances in 401(k) plans also have stronger legal protections. However, administration fees on 401(k) plans can be higher than those compared to other rollover options. Further, your employer’s plan may have limited, unappealing options for investment choices.
Another option, is a rollover. You can rollover your vested account balance directly to an Individual Retirement Account (IRA) or other qualified retirement plan (your new employer’s 401(k) may fit the bill). The rollover should be direct, trustee-to-trustee so that you don’t risk receiving the funds personally and triggering negative tax consequences. Benefits of a rollover include greater investment options (if you go with an IRA, for example), and generally lower administration fees. You can also think further down the road and decide if you want to maybe work on Roth conversions if you have the money to pay the tax and if Roth fits into your plan.
Withdrawal of funds is also an option, but not a good one. This is usually not recommended because of the likely negative tax consequences. Most who are under age 59 ½ will face ordinary income tax plus a 10% penalty on the amount withdrawn. That amount can be hefty during a job change or spate of unemployment. It also derails your retirement savings. There is one exception – the rule of 55. If you separate from service (for any reason) in the year you turn age 55, or older, you can tap the money in your 401(k) and only pay the ordinary income tax rate and not suffer the 10% penalty. This withdrawn amount has to be from the 401(k) account of the employer you just left and cannot be from a prior 401(k). It’s also worth noting that you cannot use this withdrawal approach if you rollover the account to an IRA. If you do that, you lose the privilege. If you are considering this move, check the rules closely and contact a financial planner.
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