Leaving a job due to a lay off, termination, or move can be a stressful process. The decision of what to do with a 401(k) only adds to the stress and confusion. Fortunately, choices are fairly limited as to what a former employee can do with a 401(k) after leaving a job. Most importantly, one should consult with the human resources department, as well as an accountant or financial advisor, or do in-depth research oneself. Be aware of pertinent deadlines for decisions that must be made concerning the future of the 401(k).
The Internal Revenue Service (IRS) requires the administrator of the 401(k) to send an explanation of the options available to the former employee within 30 to 90 days of the decision deadline. During this period, it is important to fully research the options available. Of course, these will depend on whether one has a new job already, whether the new employer offers a qualified retirement plan, and one’s financial situation. If money is tight, and the money in the 401(k) must be accessed to cover living expenses, this is an option, albeit an expensive one.
If the former employee does nothing about his or her 401(k) with the former employer, the administrator may decide to have the 401(k) distributed directly to the owner of the plan. There is an automatically charged 20% tax, often withheld directly by the administrator. If the owner is younger than the retirement age of 59½, he or she may also be hit with an early withdrawal penalty of 10%. Depending on one’s tax bracket and earnings for the year, there may be additional taxes owed on an early withdrawal.
A second option may be to keep the 401(k) as it is, with the same institution. This may not always be an option for many reasons. For example, it may cost the former employer to keep the account active.
Some employers may choose to charge former employees fees to maintain the 401(k). The former employee’s 401(k) may only be eligible with a minimum balance of 3,500 to 5,000 US dollars (USD). The individual may continue to contribute to the 401(k) on his or her own, without the matching funds of the employer.
Another option is to transfer the 401(k) to a qualified retirement plan at the new employer’s financial institution of choice. Some lose value in the plan during the rollover due to the sell-off of stocks and other holdings. The former institution may have to sell all the assets, because the new institution may not have the same investments, requiring the 401(k) to be transferred in cash. Any qualified retirement plan, such as a Keogh plan or other pension plan, can be a place to transfer an existing 401(k) plan.
A fourth option for a 401(k) is to transfer it, in a process called a “rollover,” into an individual retirement plan (IRA) at the financial institution of one’s choosing. This may give one added freedom in the institution that one chooses, instead of being limited to that of the new employer. This may also be an option if the employee has not found a new job in the period allowed by the administrator of the old 401(k). Be sure to check with the financial institution if future contributions to the rolled over account are tax deductible, because in some cases, they may not be if one is contributing to another investment plan in the same year. With all options that involve transferring funds from an old 401(k) into another qualified retirement plan, be sure to use a “direct rollover,” so that the money never touches one's hands, triggering unwanted taxes.