401(k) Distribution Options
The average American changes jobs multiple times throughout their career. If you’re amid a job change, you may be asking: “What happens to my 401(k) now?”
When leaving an employer, you have four primary options for your retirement savings. Each has pros, cons, and potential tax implications—so it’s essential to understand your choices and consult a qualified tax or legal advisor before making a decision.
1. Keep Your Funds in Your Former Employer’s Plan
Depending on your vested account balance and the rules of your former employer’s plan (see your Summary Plan Description or SPD), here’s what typically happens:
- Balance under $1,000: Your account may be automatically cashed out and sent to you as a check. This amount will have 20% withheld for federal taxes and may be subject to additional income tax and a 10% early withdrawal penalty if you’re under age 59½.
- Balance between $1,000 and $7,000: Your former employer may have the option to automatically roll your funds into an IRA with a pre-determined fund company.
- Balance over $7,000: You can generally keep your funds in the plan, as long as you’re satisfied with the investment options and are aware of any ongoing plan fees. Be sure to consider how this account aligns with your overall retirement strategy.
Note: Even if you choose to leave your funds in the plan now, you can explore other options at any time in the future.
2. Transfer Over Funds to Your New Employer’s Plan
If your new employer offers a 401(k) and accepts incoming rollovers, you can transfer your balance into the new plan. This option can help you consolidate your retirement savings and simplify account management.
- Check your new plan’s SPD for eligibility.
- Request rollover paperwork from both your previous and current plan administrators.
- A trustee-to-trustee transfer (where the funds are moved directly between plans) is the preferred method, as it avoids mandatory withholding and potential tax consequences.
3. Roll Over Funds into an IRA
Rolling over your 401(k) into an IRA provides greater control over your investment options and may lower fees. To avoid taxes and penalties, it’s best to request a direct rollover, also known as a trustee-to-trustee transfer, where the check is made payable to the IRA custodian for your benefit (FBO). This ensures that the 20% federal tax withholding is not applied. If you instead receive the funds directly, you’ll have 60 days to roll the full amount into an IRA to avoid taxes and potential penalties. Remember that if taxes were withheld, you would need to replace those withheld funds from your resources to complete the full rollover and avoid income tax on that amount.
4. Take the Funds as a Cash Distribution
This option is the least advisable, as it could lead to substantial tax implications. If you choose this route, 20% of your distribution will be automatically withheld for federal taxes. In addition, if you are under age 59½, you may also face a 10% early withdrawal penalty and owe additional income tax when you file your return. If you decide later, within that 60-day window, to use the funds to open an IRA, you will be responsible for providing the cash to ensure the IRA contribution reaches the full amount.
Note: In cases of financial hardship, it may be wise to withdraw only the amount you need and roll the remaining balance into an IRA or your new employer’s plan to preserve your retirement savings and minimize tax consequences.