What Should I Do With My 401k When I Leave My Job? 6 Options
Did you know that the average American will have between 6 and 7 different employers in the course of their professional career?
And, as we migrate from employer to employer, we’re faced with questions about how to handle the transition of assets we’ve accumulated through our employee benefits.
The largest of these is typically your 401(k).
There are several options for your old 401(k) when you change jobs. Everything from leaving it where it is to completely liquidating the account are on the table.
Let’s walk through these options and paint a clearer picture about which one may be the best path for you.
Option #1: You Can Withdraw the Balance
If you’re under 59.5 years old, I’m not a big fan of this option.
The reason this isn’t a great option is because you’ll owe applicable income taxes on any distribution plus a 10% early withdrawal penalty.
That’s a hefty bite out of your 401(k) balance.
For example, assume you are 45 years old, have a traditional 401(k) balance of $100,000, and you’re in the 22% tax bracket. If you took a distribution when you left your previous employer, you’d owe $22,000 in taxes and another $10,000 in early withdrawal penalties.
That’s a third of your 401(k) going to Uncle Sam instead of growing in a tax-deferred retirement account.
Not only that, but you’ve surrendered $100,000 of tax-advantaged growth that you can’t replace. It’s not as if you can reserve that space in a 401(k) for a later date. Once the contribution or rollover window is gone, it’s gone for good.
I realize that you may be leaving your employer against your will due to a layoff. If that’s the case, you may find yourself with a sudden concern about cash, tempting you to liquidate the 401(k).
Having been laid off before myself, I understand the predicament.
This is exactly why we recommend holding three to six months of expenses in an emergency fund at Milestone 4 on the Next Dollar Roadmap.
A layoff is often a very emotional experience. It’s not a great time to be making hasty financial decisions. The emergency fund provides peace of mind when things suddenly become less certain.
Option #2: They Send You a Check, Whether You Want It Or Not
If you have less than $1,000 in your 401(k) the custodian may elect to liquidate your balance and mail you a check (minus any applicable taxes).
This could be quite inconvenient because if you receive a distribution from your 401(k), you’ll have 60 days to roll the balance into another retirement account before the distribution becomes taxable.
Miss this 60-day window, and you’ll have to pay income tax on the distribution (unless the correct amount was withheld) and you’ll lose the opportunity to roll it into an IRA.
If you have a small 401(k) I’d suggest that you act quickly when you change jobs while you may have the opportunity to direct the plan custodian how to handle the balance in the account.
Option #3: They Roll It Into an IRA, Whether You Want It Or Not
In 2024, if your 401(k) balance is under $7,000, your plan custodian may elect to roll your 401(k) into an IRA.
Once again, they don’t need your permission to do this.
If you don’t already have an IRA, they can simply open one for you and drop your assets into the account.
However, if you act quickly enough you may be able to direct how these funds are handled instead of waiting to see if the custodian makes a wise move on your behalf. This includes moving the funds into an IRA of your choosing, even if it is handled by a different company.
Odds are, if left up to them, they’ll do whatever best suits them. This might even include leaving the 401(k) alone where you can continue to manage it as you wish (though you won’t be able to make any other contributions).
By now, I hope you’re seeing that procrastination rarely serves you well when it comes to managing an old 401(k).
Option #4: Leave Your 401(k) Where It Is
Many people elect to just leave their 401(k) where it is.
Frankly, this is a perfectly acceptable option. If your old plan has sufficient investment choices and the expenses are reasonable, then there’s no real harm in leaving it there to continue growing.
I can think of several reasons someone might prefer this route.
First, it generates the lowest level of hassle. You literally just leave it there. That’s it. It’s still your account. You can still manage it. The only real change is that you, nor your employer, can still contribute to it.
Second, if you plan to roll your old 401(k) into a plan at your next employer, there’s not really any point in moving it elsewhere in the meantime.
Again, why generate hassle if you don’t have to?
Finally, if you want to avoid the pro rata rule and make Backdoor Roth IRA contributions, it makes sense to leave your 401(k) as a 401(k) and not roll it into an IRA.
If you’re unfamiliar with Backdoor Roth IRAs, we wrote a post a while back about how they work. I invite you to follow the link and check it out.
A key hurdle to many Backdoor Roth IRAs is the pro rata rule that requires all IRA assets to be taxed during a conversion. If you have a large Traditional IRA balance, this could trigger an inconvenient tax bill when attempting a Backdoor contribution to your Roth IRA.
By leaving your 401(k) where it is, you won’t have to worry about it blocking a potential conversion.
On the other hand, if your 401(k) has high fees and/or poor investment options, you may want to move it to a new plan (option #5) or into an IRA (option #6) so you have more control over those characteristics.
Finally, if you’re leaning in this direction, be sure to check and see if the custodian charges any additional fees for being an inactive employee in the plan. If they do, you’ll probably want to consider another option.
Option #5: Roll Your Old 401(k) Into Your New One
If you plan to find another job after you leave your current one, you will probably have the option of rolling your old 401(k) into your new one.
There is no rule requiring your new employer’s plan to accept rollovers, but I can’t think of any reason they wouldn’t, and I’ve never heard of a plan that won’t.
The reason is simple. The more assets you have in the 401(k) they manage, the more they get to collect in fees for managing the plan.
A primary reason for using this option is to reduce the hassle of having to manage multiple plans, scattered across multiple custodians.
Not only is it a headache, it makes asset allocation more challenging.
With that said, if your new 401(k) is inferior to your old plan, you may want to leave the old one where it is or roll it into an IRA (option #6).
Be sure to compare the expenses each custodian charges for managing their respective plans, as well as take a hard look at the investment options that are available.
In the long run, you’ll probably be better off in the plan that provides the best range of investment options at the lowest cost.
If you choose a rollover, be sure to read the section titled “About Rollovers” below.
It’s about rollovers.
It also provides some important details to keep in mind so you don’t fumble your rollover and create a giant tax problem for yourself.
Option #6: Roll Your Old 401(k) Into an IRA
As I was writing this post it occurred to me that I have changed employers four times and have been forced to choose a path for my old 401(k) four times now.
Each time, I’ve elected to roll my old 401(k) into an IRA.
The primary reason for me has been cost.
I have IRAs (both Roth and Traditional) at Vanguard (not an endorsement) because of their renown for having the lowest cost index funds anywhere.
My old 401(k) plans have had decent investment options, but the costs simply aren’t competitive with Vanguard.
Additionally, by rolling those old 401(k)s into a Vanguard account, I moved from having a somewhat limited slate of investment options to being able to buy anything I wanted.
Finally, it makes asset allocation much easier.
Odds are, you can achieve the same level of low-cost flexibility by moving your 401(k) into an IRA.
The only regret I’ve ever had about this approach is that it has effectively blocked me from using the Backdoor Roth IRA strategy for many years now.
A Backdoor Roth IRA would be a costly conversion for me due to the pro rata rule.
The good news is that most 401(k) plans now offer a Roth option, meaning you can potentially contribute more to a Roth through your 401(k) than you can in an IRA anyway.
If you want to make a Backdoor Roth IRA contribution, you could consider rolling your Traditional IRA into a 401(k) if your plan custodian will allow it.
About Rollovers
A word of caution for those of you who pursue options 5 or 6 above…
There are two ways to do a rollover.
You can ask for a direct rollover, meaning your old 401(k) is moved from the custodian of your old plan directly to the custodian of your new plan and you never touch the money.
Or…
The other option is an indirect rollover where the assets are distributed to you (probably with taxes withheld) and then you have 60 days to get the funds to your new 401(k) or IRA custodian.
If you set up an indirect rollover and hold the funds for more than 60 days, it will be viewed as a distribution and you’ll owe income taxes and early withdrawal penalties on the whole tax-deferred balance.
That wouldn’t be much fun, would it?
I strongly encourage you to take the time to navigate the direct rollover if you can. It’s not really any more complicated than an indirect rollover and it allows you to completely mitigate the risk of triggering a huge tax problem.
Some plans will not send a check to your new custodian, so you may not have any choice but to do an indirect rollover.
Conclusion
Changing jobs can bring with it several administrative headaches but ignoring your old 401(k) plan probably isn’t something that will benefit you.
The primary thing is to be proactive in selecting an option that suits you. This will provide you with the opportunity to control and maximize your old 401(k) assets for your benefit, instead of living with a bit of regret for not acting sooner.
And remember, it’s your 401(k). Your old plan administrator is not under any obligation to suggest that you adopt a strategy that doesn’t also benefit them.
Do your research. Develop a plan. Optimize your account.
