Employers are offering 401(k) plans, with their tax advantages, as an advantage to attract and retain talent. Increasingly, however, Americans with 401(k)s are not working with a single company for their entire career. Today, people typically stay with a company for about 4.1 years, according to the US Bureau of Labor Statistics.
Employees who change jobs can transfer their 401(k) from their former employer to their new employer with a direct trustee-to-trustee transfer. But they must complete the rollover within 60 days and follow other rules for this process. This strategy has potential advantages and disadvantages to consider.
Key points to remember
- When you change jobs, you can roll over your 401(k) from your previous employer.
- Rolling over an existing 401(k) can make managing your account easier.
- A potential downside of rolling over a 401(k) is that you could lose some investment options.
- You must defer a 401(k) within 60 days or face tax implications.
Options for an Old 401(k)
A 401(k) retirement plan is designed to last throughout your career until you retire, when you start making withdrawals. Whether you were fired, fired, or left on your own, you are entitled to 100% of your personal 401(k) contributions. You can decide where these funds go when you leave a job.
You have four main options for what to do with your 401(k) when you leave your employer. Each option has advantages and disadvantages.
| What you can do with a 401(k) from your former employer | ||
|---|---|---|
| Advantages | The inconvenients | |
| Cash it in | Flexibility in the use of funds | Tax consequences for withdrawals before retirement age |
| Leave the account with your former employer | Maintains investments; no transfer process | Must manage account with former employer with any new account |
| Roll to a Traditional Individual Retirement Account (IRA) or Roth IRA | Investments enjoy similar tax benefits | May lose investment options from former employer |
| Roll up to your new employer’s 401(k) plan | Investments enjoy similar tax advantages; easy to manage account | May lose some investment options from former employer |
If you have $1,000 to $5,000, your former employer can transfer funds from your 401(k) to an Individual Retirement Account (IRA) of their choice. If you have less than $1,000, he can just write you a check. If you receive a check, you must deposit it in a tax-advantaged retirement account within 60 days to avoid penalties.
Indirect Rollover vs. Direct Rollover
There are two methods you can use to turn an old 401(k) into a new one: an indirect rollover or a direct rollover.
A direct rollover occurs when money from your old account is transferred directly to your new account without you ever touching the funds. You can do this by contacting the plan administrator and asking them to transfer the funds to another pension plan without any tax withholding.
An indirect rollover occurs when you receive a check in your name covering the full amount of your previous 401(k). When you receive this check, you have 60 days to deposit the funds into a new retirement plan, whether it’s a new 401(k) plan or a completely different retirement plan. Financial institutions generally withhold about 20% tax. When making your deposit, you must ensure that you include this 20%; otherwise, it could be considered an early distribution and you could face penalties.
Benefits of switching to a new 401(k)
Moving from an old 401(k) to a new one has several advantages:
- Potentially more profitable: Every 401(k) is different. Compare the costs between your old plan and the new one. In many cases, your new plan may be more profitable.
- Simplified management: It is usually easier to manage one account rather than multiple accounts. By transferring your old retirement plan to your new employer’s 401(k) plan, you can keep all the information in one place. A recent study by Capitalize estimated that there were 24.3 million forgotten 401(k) accounts holding $1.35 trillion in assets as of May 2021.
- Benefits of the “Rule of 55”: If you retire or lose your job at age 55, you can withdraw funds from your pension fund without incurring penalties. This is called the “rule of 55” and it only applies to your last employer. Funds from a previous employer’s plan are not eligible.
- Continued growth can worsen: By converting your old 401(k) to a new one, you can ensure that you will continue to earn interest on those funds. Over time, compound interest will help your retirement account grow.
Disadvantages of switching to a new 401(k)
- Potentially different rules: Your new employer will have control over the new plan and can change certain aspects of it, such as the fees and plan administrator.
- Possibility of higher fees: Higher fees can reduce your income. Be sure to check the fee structure before choosing to upgrade to the new plan.
- Loss of investment options: The number of investment options in 401(k) plans has declined in recent years. This means that other retirement plans like IRAs could offer a wider range of investments that you can use to diversify. A new 401(k) plan may not offer the same investment choices as your original plan.
What else can I do with a 401(k) when I leave a job?
In addition to transferring your 401(k) to a new plan, you can transfer the 401(k) to a new or existing Individual Retirement Account (IRA), leave it as is with your old employer, or cash it out. Each option has its pros and cons to consider.
What fees and taxes will I have to pay if I cash out my 401(k)?
Cashing out a 401(k) is akin to an early distribution of notice from the Internal Revenue Service (IRS). Taking such a step means that your withdrawals will be taxed at the state and federal level as income. Also, unless you are 59½ or older, the IRS charges a 10% penalty for early withdrawal.
How can I find old 401(k) accounts?
If you completely forget an old 401(k) or think you’ve lost a 401(k), you can take steps to find it. If your former employer is still active, you can contact him directly for any information. You can also try contacting the plan holder. Another option is to use your state’s database of unclaimed 401(k) plans.
The essential
A 401(k) provides a valuable savings tool to help you reach your retirement goals. You can switch from a 401(k) to a new 401(k), but before you do, consider all of your options. You can also cash it out, transfer it to a self-owned IRA, or leave it with your original employer. Each of these options has pros and cons to consider.