What to Do with Your 401(k) Account When You Leave the Job

Despite the fact that the stock market may have depressed the value of your 401(k) account, you may still hold substantial wealth there. When you leave the company because you’re changing jobs, being laid off, or retiring, what should you do with the funds in your account? Here are some points that can influence your decision.

Options

Each plan can set its own rules on what happens to the account of a departing employee. In most cases, you can leave the money where it is, take a distribution, or roll the money over to an IRA or to a qualified retirement plan of a new employer (if the plan of the new employer accepts rollovers).

Leaving the Account with the Former Employer

If you like the investment options you have with the former employer, you might want to leave the funds in place. According to a survey by Hewitt Associates, about 32% of departing employees leave their 401(k) funds with the plan. However, rolling the funds over to your own IRA (discussed below) provides you with more flexibility. And you cannot add any contributions (or receive any new employer contributions) in this account.

Plans don’t want the administrative burden of maintaining small 401(k) accounts after an employee leaves the company. If there’s less than $1,000 in your account, the plan can opt to send you a check for this amount, regardless of your preference. If there’s between $1,000 and $5,000, the plan can choose to roll the funds into an IRA set up on your behalf; it must place the money into a conservative investment.

Tax Results for Distributions

According to the same Hewitt Associates survey, about 45% of employees who leave a job take a cash distribution of their 401(k) account. This has immediate and potentially harsh tax consequences.

• The plan must withhold 20% of the distribution. If the former employee then wants to make a full rollover of the account balance (an option that remains for 60 days following the distribution), he or she must lay out the 20% portion of the distribution; it will be recouped as a tax refund when the return for the year of the distribution is filed.
• The balance in the 401(k) plan, comprised of an employee’s elective deferrals plus any employer contributions that have vested by the time of the distribution, are fully taxable.
• If the recipient is under age 59¹/₂, usually a 10% early distribution penalty applies. There are some exceptions to this penalty that can help certain individuals to escape it.

Aside the from the tax cost of the distribution, pocketing the cash rather than leaving the funds in a tax-deferred account can severely undermine your retirement savings. You cannot replace the withdrawn funds into a tax-deferred account (after 60 days), so you lose the value of compounding on the money.

Rollover Options

You can transfer the 401(k) funds to an IRA; about 23% of departing workers do so, according to the same Hewitt Associates survey. This gives you optimal flexibility in terms of the investments. It also allows you to access the money before age 59¹/₂ for a variety of purposes (such as paying for education or buying a first home) without penalty; most of these exceptions to the early distribution penalty do not apply to qualified retirement plans.

If you want the account funds to be moved to your own IRA, it is advisable for you to make a “direct rollover.” This avoids the 20% withholding tax. Simply instruct your IRA custodian or trustee of your wishes, and the paperwork will be sent to the plan administrator.

You are also permitted to transfer funds directly from your 401(k) plan to a Roth IRA. However, this will result in immediate tax on the value of the account. To be eligible for a rollover to a Roth IRA, your adjusted gross income (AGI) in 2009 cannot exceed $100,000. Starting in 2010, there is no AGI limit.

You can also make a direct rollover of the 401(k) funds to the qualified retirement plan of a new employer. This may be beneficial if the investment options of the new employer’s plan have lower fees than you could obtain by investing through your own IRA. Verify that the new employer’s plan accepts such rollovers; it is not required to do so.

Outstanding Plan Loans

Be sure to recognize that if you’ve borrowed from your 401(k) account, you must repay the loan when you leave the job (usually within 60 days or so, according to plan rules). If you fail to repay the loan, it is treated as a taxable distribution to you.