When you quit your job, you have five options for your 401(k):
- Keep it with your old employer
- Roll over to your new employer
- Roll over into an IRA
- Retire, if you are of age
- Cash out
If you’re considering quitting or transitioning jobs, you may be wondering what to do with your 401(k). Each of the options above has benefits and drawbacks, and you should carefully consider what’s best for you.
Before you decide what to do with your 401(k), make sure you don’t have a loan on your 401(k). 401(k) loans are appealing because they don’t affect your debt-to-income ratio — however, if you can’t repay it by the tax due date after leaving your job, you’ll be taxed on the balance and charged an early withdrawal fee. Some companies offer special options here, so you should always check with your 401(k) administrator and plan documents.
You’ll also want to keep in mind the fact that some account types only allow one rollover per year — so if you’re changing jobs frequently, this is something to be aware of. Refer to this chart from the IRS to learn more about account rollovers.
With this in mind, you have the following options for your 401(k) when quitting your job:
Option 1: Keep Your 401(k) With Your Old Employer
Many are surprised to learn that in certain circumstances, you can leave your 401(k) with your old company’s retirement plan. However, if you have less than $5,000 in retirement savings, your company may force you out by issuing you a check. If they issue you a check, it’s crucial that you transfer the funds into a new 401(k) within 60 days, or else you’ll have to pay income tax on the distributed balance.
Leaving your retirement savings with your old employer has its drawbacks. For example, you won’t be able to make any more contributions to the account, and you may also not be able to take out a loan on your 401(k). Your old employer may also charge administration fees on the account now that you’re no longer an active participant. Additionally, you’re still locked in to the funds that plan offers, which may be limited and expensive. For these reasons, many people — particularly those new to the workforce — choose to roll over their 401(k) to their new employer.
Option 2: Roll Over Your 401(k) To Your New Employer
The most common route people take is rolling over their 401(k) to their new employer. Typically, this is done through a direct transfer or having your employer automatically transfer your 401(k).
Alternatively, you may opt for your employer to mail you a check for you to manually deposit into your new 401(k). The 60-day rule applies again here: If the funds aren’t deposited into a new 401(k) after this time, you’ll pay income tax on the entire balance.
Before transferring your funds to a new 401(k) plan, make sure you understand your new plan’s rules, fees, and investment options. Look into your new company’s 401(k) matching program, if there is one. Make sure you’re making the most of your new 401(k) plan by knowing all your options and seeing if your new plan is better or worse than what was available at your previous employer.
Option 3: Roll Over Your 401(k) Into an IRA
Instead of keeping your funds in a 401(k), you may also choose to roll over your plan into an IRA. You’ll do this with a bank or brokerage firm separate from your employer. This is a common choice for people who are leaving the workforce or for those who don’t have an employer that offers a 401(k) plan.
The main benefit of an IRA versus a 401(k) is more flexibility in withdrawing money penalty-free before reaching the age of 59 ½. You also have direct access and more control over your investment options. You may have other investments and can now move this money to the same brokerage so that everything is in one plan, which consolidates logins.
If you choose to withdraw money from a rollover IRA, it may be used for a qualifying first-time home purchase (up to $10,000) or higher education expenses in addition to the exceptions for 401(k)s.
The drawbacks of an IRA is that you’ll lose some hardship distribution options as well as “qualified” status, which means less protection of your assets. For example, if you were to be sued, some states would allow money in IRAs to be collected — but not if it was in a 401(k).
Option 4: Retire
If you’re over the age of 59 ½ and decide to retire after leaving your job, you may start taking qualified distributions from your 401(k) or IRA without being charged an early penalty fee. Your distributions will, however, be taxed at your normal income tax rate.
If you are over 55 but not yet 59 ½, you may take penalty-free distributions from your 401(k) but not an IRA. However, this is only valid if you’re accessing the 401(k) from your current employer. If you left your 401(k) with a previous employer, you’ll need to wait until you’re 59 ½.
If you’d like to make withdrawals from your 401(k) after you’ve turned 59 ½ but are not yet retired, check with your employer’s plan to see if you’ll be penalized.
Once you turn 72, you’ll be forced to take required minimum distributions (RMDs). If you fail to take your RMDs — or do not take out enough — you’ll be charged a whopping 50 percent penalty. This means if you were supposed to take out $2,000, the IRS will take $1,000. The IRS created the RMD rule to ensure tax is paid on 401(k) and IRA accounts when the money is withdrawn.
Option 5: Cash Out
You can, of course, cash out your 401(k) when you quit or leave a job. However, this isn’t typically advised for a number of reasons.
When you cash out your 401(k) before the age of 59 ½, you’ll be required to pay income tax on the full balance as well as a 10 percent early withdrawal penalty and any relevant state income tax.
So, for example, if you cash out $10,000 from your 401(k) and you’re in the 22 percent federal tax bracket, you’ll pay a total of $3,200 in taxes and penalty fees. That’s nearly a third of your savings — and that doesn’t even take into account possible state income tax.
As long as your funds are in your 401(k), they are creditor-protected, meaning the money is safe in the event that you’d need to file for bankruptcy. Once you cash out, your money can now be sought after by creditors and bankruptcy courts, so don’t cash out if you think you may need to file for bankruptcy.
Additionally, when you cash out your 401(k) early, you opt for instant gratification while robbing your older self of potential growth on investments. Your retirement funds are meant to be there for you when you need them later in life. Only withdraw if absolutely necessary — after careful consideration — with your future self’s income in mind.
Saving for retirement is something to take very seriously. When you quit your job, you have a variety of options. It’s up to you and your financial advisor to decide the best fit for your unique situation. Careful planning and diligent saving are key to putting your mind at ease and fully enjoying your retirement.