When you leave a job, you’re probably focused on cleaning out your desk and saying good-bye to work friends. But taking care of your 401(k) retirement plan at the soon-to-be-former employer should also be high on your to-do list so that you can handle that money responsibly and avoid unnecessary taxes and penalties.
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If you take a 401(k) loan from a job, you generally must repay the outstanding balance in full when you leave. Otherwise, the loan may be treated as a distribution and subject you to early withdrawal penalties.
Assuming you don’t have any outstanding 401(k) loans, here’s a look at your options.
1. Cash it out. Tempting as might be to cash out a 401(k) from a previous employer, this should be your last resort. If you cash out a 401(k) before age 59.5, you’ll be subject to taxes and early withdrawal penalties. In addition, you’ll also lose out on money that could have grown and supported you during retirement. If you have less than $5,000 in your 401(k), the plan administrator may automatically distribute funds to you, triggering a taxable distribution, so ask them about this before you leave. If you need money to help you through a career transition, explore other options first such as a home equity line of credit or a personal loan, which are typically cheaper ways to access money.
2. Leave it alone. If you have at least $5,000 in your old employer’s retirement account, you should be able to leave the money in the account and let it continue to grow. However, the downside of doing nothing is that it’s easy to lose track of money in an old employer’s 401(k). Lacking visibility on how the money is invested could make it harder for you or your financial advisor to create a diversified portfolio. Plus, many employer 401(k)s carry high fees that can eat away at the money you’re saving for retirement.
3. Roll it over to your new employer’s 401(k). If your new employer allows rollover, you could directly rollover funds from your previous employer’s 401(k) to your new 401(k) to avoid taxes and penalties on an early withdrawal. This can also help you consolidate your retirement accounts so you have fewer accounts to monitor. However, an individual retirement account (IRA) may have lower fees and broader investment options, so consider the fees and investment options of your new employer’s 401(k) before you initiate a rollover.
4. Roll it into an IRA. Rolling over your previous employer’s 401(k) into an IRA can mean lower fees and more varied investment options than moving into your new employer’s 401(k). IRAs come in two flavors: traditional and Roth. Both carry the same contribution limits ($5,500 per year or $6,500 if you’re age 50 or over), but contributions are treated differently for tax purposes. A traditional IRA uses pre-tax money — similar to a 401(k) — so you pay taxes when you withdraw the money, while a Roth IRA contains post-tax money. To get your 401(k) money into a Roth, you’d first roll it over to a traditional IRA and then convert it to a Roth.
To avoid penalties with an IRA rollover, fill out the required paperwork for a trustee-to-trustee transfer so that your old employer transfers funds directly to your IRA custodian on your behalf. If you do an indirect transfer and the check is made out to you, then your employer is required to withhold 20 percent for federal tax. You’d need to add the difference out of your own pocket to avoid getting hit with a 10 percent penalty for early withdrawals.
Career transitions can be exciting (or sometimes overwhelming), but don’t neglect your retirement accounts in the process. A direct transfer to a new 401(k) or an IRA can help you manage that money and grow your nest egg for retirement.
Susan Johnston Taylor is an Austin, Texas-based freelance writer for TraditionalIRA.com and RothIRA.com. She has covered personal finance and small business for publications including The Boston Globe, Entrepreneur, Fast Company, and U.S. News online.
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