The career path of the average worker has changed dramatically over the past few generations. While my generation is more apt to leave a job and work for several companies throughout a lifetime, previous generations are famous for maintaining work with the same company for the entirety of a career. That amazes me, especially considering that I have (barely) three years of post-undergrad experience and am currently on my third job. I like my current job; I believe it’s going to stick for a while, but that doesn’t change the fact that I left my first job out of undergrad in less than 6 months, and then followed that up with a stint at my second job that barely lasted a year. I wasn’t fired from either job; I left voluntarily and on good terms at both locations. My reasons for leaving were due to a hastily run job search process (both times) leading to dissatisfaction with each organization and is material probably better served with its own post. Regardless, leaving two jobs means rolling over two 401(k)s, and the bevy of information and options that is associated with a rollover.
When I sat down to write this post I decided to take a look at the US Tax Code. Officially, I did it to glean background information, but in reality I was just curious to see what it was like. One thing it was not was brief. Or organized in a fashion that I could comprehend and peruse easily. It soon become abundantly obvious how people can devote their whole lives to studying and applying the tax code, and it made me even more suspicious of my neighbor, who, every tax season, puts up a home-made construction-paper sign advertising tax help. I think I’ll stick to Turbo-Tax, thanks though…
Despite the intimidating nature of the tax code, understanding how it is applied in the case where you leave your job and want to maintain active control over your 401(k) is enormously important. You have options when it comes to managing that money, and each option has very different tax ramifications.
As a little background, a 401(k) plan (and similarly, a 403(b) plan) is a Defined Contribution Plan (DCP), which establishes a partnership between an employee and an employer. It allows for the employee to specify a yearly contribution amount and the employer to specify a matching program. The US Tax Code provides tax protections for each party; most importantly, the ability to contribute money pre-tax, thus putting off the income tax burden until funds are withdrawn at the retirement age (59 1/2), or at an earlier time if the employee wishes to make an early withdrawal, which is subject to its own set of taxes and penalties. Now there are special exceptions (“hardship” clauses, for example), and certain types of 401(k) plans where contributions are made post-tax (known as “Roth 401(k)s”), but most people have either a standard 401(k) (or 403(b)) so that’s what we’ll focus on.
So you’ve left your job and you want to know what your options are for your 401(k). Despite the complexity of the tax code, you essentially have four basic options. You can either keep the money where it is and ignore it, roll it over to a standard IRA, roll it over to your new employer’s 401(k) or cash it out.
*#1 Keeping Your Money Where It Is*
This is typically not a recommended option. It’s perfectly fine to do these; you won’t incur any penalties for doing so, but you won’t be able to contribute any more money to the 401(k), and some employer programs have specific rules set in place to hamper management of the money in the 401(k). I’ve heard anecdotally of individuals who have left their money in their old employer’s 401(k) plans for extended periods of time (years) and when they attempted to withdraw the money or transfer it, they ran into difficulties with their old employer’s fund manager and the transition was less than smooth. When I left my second job I held the money in that account for a couple months, until I found out that I was unable to transfer money between funds in the 401(k). Hamstrung by that severe limitation, I decided to immediately roll it over into a traditional IRA. It is not the best way to manage your wealth, and definitely won’t help you with building wealth. Another issue to be aware of is if your 401(k) contains less than $5,000, your old employer can opt to cash you out of their program. If that is the case, then your money will behave just like option #4
*#2 Roll Your Money To A Standard IRA*
This is the option that I have selected in the past. If initiated as an institution-to-institution transfer, you will incur no penalty and your funds will be placed in a traditional IRA. However, if for whatever reason you act as a middleman between each institution (ie your employer’s fund manager mails you a check, you give the check to whoever is managing your IRA, even if you don’t deposit or cash is prior to doing so) you will be viewed as having cashed out your 401(k) and you will be subject to penalties just like option #4. This option is very similar to option #3; the reason why I’ve elected to go this route is because it allows me complete flexibility in choosing what to do with my money, as opposed to rolling it over to your new 401(k), which forces you to place your money in one of your 401(k) plan’s designated funds. Also note that you can only roll a 401(k) over to a traditional IRA, not a Roth IRA, because of the how each IRA is viewed under the tax code.
*#3 Roll Your Money To Your New Employer’s 401(k) Program*
This is the most common solution, and logistically, it is very similar to option #2. Again, be sure to not act as an intermediary between institutions or else you will be severely penalized. Communication is crucial with this option, as you have to work with fund managers from both your past and current employer. The advantage to this option over option #2 is sometimes certain 401(k) programs have excellent fund options that are unique to that specific employer’s plan. If you’re looking at your options with your new employer and see a nice mix of well-performing options with low expense ratios, it wouldn’t be that bad of an idea to roll your old plan’s money over to your new 401(k).
*#4 Cash Out*
This is widely considered the worst option of the four, outside of a few specific extenuating circumstances. If you decide to cash out your 401(k), you’re looking at that money being taxed as income, as well as a 10% penalty. Additionally, that money may be subject to state and local taxes. Choosing this option WILL cost you a lot of money. Also, if you have loaned yourself money out of your 401(k), you are generally required to pay that money back within 60 days of you leaving the company. Even if you want to take the money out to pay off credit card debt, or a home equity loan, or to pay for a child’s education, I strongly encourage you to consult with a financal professional and reconsider. It may seem like a good idea at the time, but in almost all cases, it ends up hurting you long term. Now, there are some ways to withdraw money from a 401(k) without incurring a penalty, but that money is still subject to income tax. A few of those reasons are: permanent disability, death of the plan participant and in the case of deductible medical expenses exceeding 7.5% of your gross annual income. As always, consult with a tax professional (or your employer’s 401(k) fund manager representative) before making such a move.
When you leave a job, you do have options for how to handle your money. As with any instance where you are considering a change in your financial situation, be sure you understand all of your options very clearly before making a move. If you can’t, don’t be afraid to contact a professional financial consultant or your 401(k) plan representative.
– Michael
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