Changing Jobs? Know Your 401(k) Options

If you’ve lost your job or are changing jobs, you may be wondering what to do with your 401(k) plan account. This can be an important decision, and understanding your options can help you avoid unnecessary taxes, penalties, or lost benefits.

What will I be entitled to?

If you leave your job, whether voluntarily or involuntarily, you’re entitled to a distribution of your vested balance. Your vested balance always includes your own contributions to the plan, including pre-tax, after-tax, and Roth contributions, along with any investment earnings on those amounts. It also includes employer contributions and earnings that have satisfied your plan’s vesting requirements.

Vesting determines how much of your employer’s contributions you get to keep. In general, you must be 100% vested in employer contributions after three years of service under a “cliff vesting” schedule. Alternatively, plans may use “graded vesting,” where you vest gradually, typically 20% per year, until you’re fully vested after six years. Some plans have faster schedules, and others provide immediate 100% vesting. You’ll also be fully vested once you reach your plan’s normal retirement age.

Because any employer contributions that haven’t vested by the time you leave your job are forfeited, it’s important to understand your plan’s vesting schedule. This information is outlined in your summary plan description (SPD). If you don’t have a copy, you can request one from your plan administrator. If you’re close to becoming fully vested and have flexibility in your timing, it may make sense to delay leaving your job.

Don’t spend it

Although the balance in your 401(k) may look tempting, spending it should be a last resort. If you take a distribution, you’ll generally owe ordinary income tax on the entire taxable portion of your account, excluding any after-tax or Roth contributions you’ve made. In addition, if you’re under age 55, a 10% early withdrawal penalty may apply unless an exception applies. Special rules may apply if your distribution includes employer stock.

If your vested balance exceeds $7,000, you may leave your money in your employer’s plan at least until you reach the plan’s normal retirement age, which is typically age 65. You may also choose to roll the funds over to an IRA or to another employer’s 401(k) plan, if the new plan accepts rollovers.

A direct rollover is usually the preferred option. In a direct rollover, the funds move directly from your 401(k) to the IRA or new employer plan without passing through your hands. This avoids mandatory withholding. By contrast, with a 60-day rollover, the distribution is paid to you, and your employer must withhold 20% of the taxable portion. You can still roll over the full amount, but you’ll need to replace the withheld amount from other funds until you recover it when you file your tax return.

Should I roll over to my new employer’s plan or to an IRA?

If both options are available, there’s no single right or wrong answer. The best choice depends on your financial situation, goals, and priorities. Because this decision can have significant long-term consequences, working with a qualified professional may be helpful.

Reasons to consider rolling over to an IRA

An IRA generally provides more investment choices than an employer-sponsored plan. With an IRA, you can typically choose from a wide range of investments and move your money freely among them. Employer plans often offer a limited investment menu.

IRAs also offer flexibility in choosing custodians. You can transfer funds between IRA trustees as often as you like through direct trustee-to-trustee transfers, which aren’t limited annually. This allows you to change providers if you’re dissatisfied with service or performance, and it can allow you to spread assets across multiple institutions for diversification. Employer plans don’t offer this flexibility unless you leave your job.

Distribution flexibility is another advantage. The timing and number of withdrawals from a 401(k) are governed by the plan’s terms and may be limited. With an IRA, distributions are generally at your discretion until you reach the age at which required minimum distributions apply.

You can also roll over your 401(k) balance to a Roth IRA. While you’ll generally owe taxes on the amount converted (excluding after-tax contributions), qualified withdrawals from a Roth IRA in the future are tax free.

Reasons to consider rolling over to your new employer’s plan or staying in your current plan

Many employer-sponsored plans allow participant loans. If your new employer’s plan permits loans, you may be able to borrow up to 50% of the amount rolled over. Loans aren’t available from IRAs; accessing IRA funds generally requires taking a distribution that may trigger taxes and penalties. While a 60-day rollover can act as a short-term loan, this strategy is limited to once per 12-month period.

Employer plans also tend to offer stronger creditor protection. Most 401(k) plans are protected from creditors under federal law, even outside of bankruptcy. IRA creditor protection is more limited and often depends on state law unless bankruptcy is declared.

Another consideration is required minimum distributions. Traditional IRAs generally require distributions to begin by April 1 following the year you reach age 73 (or age 75 for those who reach age 73 after December 31, 2032). However, if you continue working and participate in your employer’s 401(k), you may be able to delay distributions until after you retire, provided you own no more than 5% of the company.

If your distribution includes Roth 401(k) contributions, you can roll them into either a Roth IRA or a Roth 401(k) in your new employer’s plan, if allowed. Rolling into a Roth IRA may trigger a new five-year holding period if you’re establishing your first Roth IRA. Rolling into a Roth 401(k) preserves your existing holding period, which may allow earlier access to qualified tax-free distributions.

Before initiating a rollover, be sure to ask about surrender charges, compare fees and expenses, and understand any guarantees or benefits you may give up by transferring funds.

What about outstanding plan loans?

If you have an outstanding loan from your employer’s plan, you’ll generally need to repay it when you leave. Otherwise, the remaining balance will be treated as a taxable distribution. In some cases, you may have 60 days to roll over the amount treated as distributed to an IRA, but you’ll need to replace the funds from other sources.