If you leave a job where you had a 401(k) you’re faced with a decision: what do you do with the 401(k) account at your old job? The money in your 401(k) belongs to you (excluding any matching funds that aren’t fully vested yet) so you need to decide what to do with it. You’ve got four basic options.
1. Keep it where it is in the old company 401(k) plan
If your company allows it (most do) you can leave your 401(k) account where it is. The upside to this is simple; you don’t have to change anything. If you like the investment options in the plan, it may be a good option for you to leave it as it is. There are no taxes or early withdrawal penalties with this option.
The downside is that it’s one more thing to keep up with. If you’ve had several jobs it may mean several “orphan” 401(k) accounts to keep up with. Another potential downside is that if your account balance isn’t large enough (over $5,000) the company can “force” you out of their 401(k) plan once you leave. If the balance is between $1,000 and $5,000 that would mean they set up a rollover IRA for you and transfer the money there. If your balance is less than $1,000 they can simply distribute the money to you (more below on why this isn’t a great option for you). You can also no longer make contributions to the 401(k) when you’ve left the company, so you’ll need to make retirement contributions somewhere else.
2. Transfer it to new company 401(k) plan
If you leave your job to start a new job that has its own 401(k) plan you can often roll the money from the old plan into the new plan.
The upside to this option is that it consolidates your accounts and gives you one fewer thing to keep track of. If done correctly (as a direct transfer or indirect rollover) there are no penalties or taxes owed. If you like the investment options in your new 401(k) account it can be a good choice for you.
The downsides to this are that not all employers offer 401(k) plans, not all 401(k) plans accept rollover contributions, and even if your new job does offer a 401(k) plan, you may not be eligible to participate until some time after you start. You also may have more limited, or higher fee, investment options in your new 401(k) plan than in your old plan.
3. Roll it over to an Individual Retirement Account
This option is very similar to rolling your old 401(k) into your new 401(k) except instead of rolling it into another employer sponsored plan you are rolling it into an individual retirement account (IRA).
The upside of this option is that it is available to basically everyone. You can open one at pretty much any brokerage, including some that offer advisory services as well to help you figure out how to invest your funds. You don’t have to figure out if your employer offers it, there’s no limit to how much or how little you can rollover, and there are a wide variety of investment options available to you, unlike most 401(k) plans. Rolling over funds from a 401(k) doesn’t lessen the amount you can contribute to an IRA in a given year, and both Roth and traditional options are available if you happen to have had a Roth 401(k) at work.
The downsides of a rollover IRA is that it can be another account to keep track of, but once you have the IRA you can roll into it multiple times. You don’t need a new one for each job change. Most IRAs are “self-directed” so you will need to make investment choices after your transfer, which can be overwhelming because of the wide variety of options available to you.
4. Cash out the old 401(k)
By far the worst choice on this list for most people, you can also simply take a distribution from your old 401(k). You’ll receive a check for the value of your 401(k), likely with 20% withheld for taxes by your old employer, and you’ll also have to pay a 10% penalty if you’re younger than 59 and a half. Unless you need the cash badly at that point, this is not your best option and can seriously set back your retirement planning.
If you do happen to get a distribution, whether it’s because you had less than $1,000 in your 401(k) and the company simply cut you a check, or you chose a cash out before you knew your other options, it may not be too late.
You have 60 days to complete what’s called an “indirect rollover” to avoid having this treated as an early distribution subject to taxes and penalties.
That means you have 60 days to deposit the full amount of the distribution into a qualified retirement account (IRA or 401(k)). That includes the 20% that was withheld for taxes, even though you don’t have that money. Here’s a quick example. You have a 401(k) with $10,000 in it when you change jobs. You decide to cash out the old 401(k) before you knew you had better options. You’ll get a check for $8,000 in the mail (that’s $10,000 minus the 20% withheld for taxes). You now have 60 days to deposit $10,000 in an IRA or your new 401(k) to have this classified as an indirect rollover. That means you need to come up with $2,000 on your own to cover the taxes withheld. If you only deposit the $8,000 from the check the other $2,000 will be treated as an early distribution, taxed, and penalized. You’ll get the $2,000 back the next time you do taxes, but why make it this complicated? A direct rollover is much easier and much less likely to cost you money in taxes and penalties.