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When you get a new job, there's a lot to think about. A new office, new coworkers, a new title—maybe even a new company car or a new wardrobe to reflect your new position. In the excitement around switching jobs, it can be easy for important considerations to get lost in the shuffle, such as what to do with the money in your existing 401(k) account. When you leave a job for a new one, you get to keep your 401(k) contributions, but you'll have to figure out what to do with them. By understanding your options, you can reduce or avoid tax liability, maximize your savings and help make sure your nest egg keeps on growing.
What Happens to Your 401(k) When You Switch Jobs
What happens to your 401(k) balance when you leave your job? In part, that depends on how much money is in your account. Regardless of the amount, you'll keep all the contributions you've made to the plan, plus the portion of your employer match that's vested.
Money withdrawn from a 401(k) is called a distribution. The plan's administrator is required by law to give you a written explanation of your distribution options, including the ability to have the money transferred directly to another 401(k) plan or to an individual retirement account (IRA).
In most cases, you can also leave your 401(k) money in your former employer's plan. However, if your plan balance is $1,000 to $5,000, the plan administrator may deposit the money into an IRA for you if you don't cash it out or roll it over into another retirement account. If your balance is less than $1,000, your plan administrator may automatically cash it out and send you a check. In this case, quite a bit of tax will be withheld. To keep your plan administrator from making a decision for you, contact them as soon as you know you're leaving your job to go over your options.
How to Handle Your 401(k) When You Get a New Job
If your former employer cashed out your 401(k) account and gave you a check, you need to roll the money into a qualified retirement account within 60 days to avoid paying taxes on it. If you didn't get a check, and you're able to park your 401(k) with your former employer for now, take some time to consider your options.
1. Leave It With Your Old Employer
As long as your 401(k) balance is $5,000 or more, you can leave the money in your former employer's plan. Doing this for a relatively short time may make sense. For example, if you were laid off and don't have a new job yet, you may want to leave your existing 401(k) as is until you get a new job that offers a 401(k), and then do a rollover (more on that in a moment).
Technically, your 401(k) money can remain in your former employer's plan as long as you want it to, but there are some good reasons not to leave it there indefinitely. For one thing, if you start contributing to a 401(k) plan through your new employer and leave your existing plan intact, you'll be paying fees on two accounts. These costs can quickly add up, which will eat into your investment earnings. Additionally, if your focus is split between two accounts, you may not be as diligent about monitoring your account and rebalancing your investments as you would if you were concentrating on one plan with your current employer. Another hazard: Your former employer could go out of business. If this happens, your 401(k) balance is still safe, but accessing the account or rolling over funds may become more complicated.
2. Roll It Over Into Your New 401(k)
If you get a distribution from one qualified retirement plan and contribute all or part of it to another qualified retirement plan within 60 days, it's considered a rollover, and the transaction isn't taxed. When you leave your job, your plan administrator will give you a written explanation of your rollover options.
Unless your former employer cashed out your 401(k) and gave you a check, you don't have to complete a rollover right away. In fact, it's often wise to wait until any probationary period on the new job is complete and you're sure you'll be with this employer for a while. You should also make sure you're satisfied with the investment options your new employer's 401(k) plan offers. If you're not, rolling your existing account over to an IRA may be a better move.
3. Roll It Over Into an IRA
Unlike a 401(k), which is sponsored by an employer, you can open an IRA on your own. You can choose from either a traditional IRA or a Roth IRA, both of which give you many investment options—a plus if you feel the 401(k) choices are too limited. For 2020, the annual contribution limit for both types of IRAs is $6,000, ($7,000 if you're 50 or older).
Roth IRAs are restricted to people below certain income levels, and contributions you make to them aren't tax-deductible; however, money withdrawn in retirement is tax-free. With a traditional IRA, contributions may be tax-deductible depending on your income and whether or not you have another retirement plan, but you're taxed on withdrawals you make in retirement.
Whether you're rolling over to a 401(k), traditional IRA or Roth IRA, make sure to roll the money directly from one retirement account to the other to avoid taxes. If your plan administrator writes a check with your name on it, that distribution is automatically subject to 20% tax withholding, even if you intend to roll the money over later.
4. Cash It Out
Sure, you can cash out your entire 401(k) balance when you leave a job—but doing so is rarely a good idea. First, 20% of the distribution will be withheld for taxes. Second, if you're under age 59½, you'll have an additional 10% tax penalty for withdrawing the money early. (The Rule of 55, which allows you to withdraw 401(k) funds penalty-free if you leave your job at 55 or older is the only exception.)
But sacrificing a huge chunk of your 401(k) balance to the IRS still isn't the worst of it. By cashing out your 401(k), you're throwing away all the compound interest you've earned over years of saving. Even if you start a new retirement account later, you'll never make up for the time lost. Unless you have several other investment accounts that you can tap for retirement, you'll be starting your retirement savings all over from scratch.
The Right Decision Depends on Your Situation
In the flurry of starting a new job, it's easy to forget about your 401(k), but neglecting this investment account can have lasting effects on your finances. To make the most of your retirement savings, carefully consider the pros and cons of each option for handling your 401(k). And don't make a move until you fully understand all the alternatives and how your decision might affect your tax liability and your financial future.