It is your last day at your current job. You may be retiring or just changing jobs. It is time to think about what you are going to do with your 401(k) investments.
Let’s start with the basics: A 401(k) plan is a type of investing account that allows you to save money for retirement and offers potential tax benefits. There are two main types of 401(k): Traditional and Roth. With a Traditional 401(k), you defer a portion of your income and receive a tax deduction in the year of the contribution. With a Roth 401(k), you defer a portion of your income and do not receive a tax deduction. Instead, your money grows tax-free and may be distributed tax-free.
Since your 401(k) is sponsored by your employer, you won’t be able to contribute to it after you leave your job. What happens to your 401(k) then? Here are your options:
- Withdraw the money. Technically, you can withdraw money from your 401(k) but you will owe taxes and will likely face penalties from the IRS, too (if you’re under age 59 ½). Unless you are facing serious financial hardship, we strongly advise against it.
- Keep it at your former employer. If you have more than $5,000 invested in your 401(k), most plans allow you to leave it where it is. If it is under $1,000, the company can force the money out by issuing you a check. If it is between $1,000 and $5,000, the company can force you out and you will have to roll it over to a Rollover IRA. The downside to doing nothing with your 401(k) is cost. You are paying maintenance fees to maintain an account to which you are no longer contributing and likely paying higher costs for the investments inside the 401(k) plan.
- Roll it to your new employer. Your new employer may allow you to move the balance to your new 401(k) plan. This might make sense if your old 401(k) balance is small and you’d like to keep all these funds in a single account rather than opening a small Rollover IRA account.
- Roll it into an IRA. You can move your entire balance to a Rollover IRA penalty- and tax-free. Why do we commonly recommend rolling over to an IRA? Investment choices! A Rollover IRA gives you countless investment choices. Most 401(k) plans have limited investment choices and higher costs, like the maintenance fees I mentioned.
Consider your options carefully and pay special attention to asset transfer rules to avoid missing a deadline or creating an unexpected taxable distribution. Horrible tax costs can be incurred by making simple mistakes, so use a trusted professional to help you with this process. For tax-specific questions, call your tax professional. There is no “one size fits all” solution when it comes to 401(k) plans. As always, we are here to answer any questions you may have and give you our recommendation based on what is best for your specific situation.