What Happens to Your 401(k) When Changing Jobs?

Should you withdraw money from your retirement account when you lose your job? Do you need to manually roll over your 401(k) during a merger? Find answers to these questions—and more—here.

Saving for retirement is one of the most important things you can do to secure a healthy, happy future. Despite this, many people don’t understand the basics of how 401(k) accounts are affected by changing—or losing—your job. Here’s what you need to know about 401(k) rollovers, withdrawals, loans, and more.

What Is a 401(k)?

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Before we get into your options for managing your 401(k), it would help to know what one is. This type of retirement account is provided by an employer and allows employees to save a portion of their pre-tax wages for retirement. Employers often match a certain percentage of employee contributions, but this is not a legal requirement. A 403(b) functions similarly to a 401(k) plan but is typically only offered to some employees of nonprofits or schools. For the purposes of this article, we’ll only be discussing 401(k) plans.

The money in a 401(k) is typically invested in mutual funds chosen by the employee to match his or her risk tolerance. Because the contributions to a 401(k) are made before taxes, providing a reduced taxable income for the employee, withdrawals from the account are taxed. In addition, early withdrawals face a 10% penalty fee—but we’ll talk more about that later.

If you are no longer employed with the company that opened your 401(k), what happens to that money? Don’t worry—it’s not gone. But you will need to make a decision about what happens next. The decision will likely depend on why you experienced a job change. Let’s look at a few different scenarios.

You Could… Leave the Money Where It Is

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Depending on how much money is currently in the account and your satisfaction with the way it is managed, you might choose to leave your 401(k) alone. However, this will only be possible if you have at least $5000 in the account. Once you hit that minimum, your former employer must legally allow you to stay on their plan. However, you will no longer be able to contribute to this account.

What if you don’t have $5000 in the account? If the balance is less than a thousand dollars, there is nothing to prevent your former employer from issuing you a check and removing you from their retirement plan. If the balance is between $1000 and $5000, they are legally obligated to help you roll over the balance into an IRA (individual retirement account) if they don’t want you to stay with their plan.

It’s unusual to stay with your former employer’s retirement plan. Most people will either roll over to an IRA or their new employer’s plan instead.

Read More: Don’t Get Blindsided By These Retirement Expenses

You Could… Rollover the Money Into an IRA

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When you change jobs and don’t (or can’t) leave your 401(k) where it was, you need to take action. One of the most popular choices is to transfer the balance into an IRA instead.

An IRA is an individual retirement account, meaning that it is not linked to your employer. You can choose where to open your IRA, as well as which “flavor” suits your investment strategy:

  • Traditional IRA
  • Roth IRA
  • SEP IRA
  • SIMPLE IRA

For now, we’ll only be discussing a traditional IRA. You can open an IRA with a broker, either online or in person, or with a bank or investment company. There are limits to how much you can contribute each year to retirement across all accounts, and as with 401(k) plans, there are penalties if you withdraw early.

One of the main benefits of an IRA is that the money is saved after taxes. Once you start withdrawing the money for retirement (or after the age of 59 ½), you will not have to pay income tax on it. You can also choose from a wider variety of investment options with an IRA instead of being limited to your employer’s plan. It’s not a bad idea to open an IRA even if you intend to continue contributing to a 401(k), just to diversify your investment portfolio.

There are special rollover IRAs for people like you who are transitioning between jobs. However, it’s very important that you do it the right way to avoid serious tax penalties. You can find a wide variety of rollover IRA options from major financial institutions. If you’re not sure which one to pick, it might be a good idea to sit down with an independent financial advisor. Some rollover IRAs require minimum deposits or charge advisory fees

Moving money from a 401(k) into an IRA won’t incur tax penalties, as long as you do it the right way. Once you decide to move your money, you’ll need to contact the administrator of the old account and ask for the balance to be sent via check to the new IRA. Alternately, you can ask for a check to be sent directly to you, but you’ll be responsible for depositing it into the new IRA within 60 days.

You Could… Move the Money into Your New Employer’s Plan

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If you experience a merger or acquisition at work, it’s more than likely that your 401(k) will be automatically rolled over into the new employer’s plan. You may not need to do anything to ensure this happens, but make sure to talk with your HR representative or plan manager to see how the process will work.

When you start a new job, it may take some time to be able to join the new employer’s retirement plan. Ask questions about how and when that process can be initiated. You can either choose a direct transfer, where the balance automatically moved over to the new account, or you can ask for an indirect rollover. The latter is riskier since the administrator of your old plan will issue you a check that must be deposited into the new 401(k) account within 60 days. Otherwise, it will be considered an early withdrawal.

Why consolidate your 401(k) accounts? Mostly, it’s for the sake of convenience. Having multiple retirement accounts of the same type will make things more difficult when it comes time to retire. It will also complicate the estate planning process. Finally, if you are after retirement age but want to keep working, any money in your current employer’s 401(k) is not subject to required minimum distributions.

You Could… Cash Out Your Account

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If you find yourself in a sticky situation, it can be tempting to look at your 401(k) as a personal piggy bank. The vast majority of financial experts advise against touching your retirement savings unless it’s truly a life-or-death emergency.

NerdWallet warns:

This is almost certainly your worst option. Not only does cashing out sabotage your retirement, but it comes with some brutal penalties and taxes levied by the IRS. You’ll pay a 10% early withdrawal fee, plus ordinary income taxes on the amount distributed. That means you might hand over up to 40% of that money right off the top.

If you’ve lost your job and are in dire straits, there’s a way to access your money without facing severe penalties. A loan against the balance of your retirement account can be a better option as long as you understand what you’re signing.

Read More: Clever Ways to Put More Cash in Your Pocket

Is a 401(k) Loan the Same Thing as an Early Withdrawal?

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If you need money fast and want to access your retirement savings, there are two options: a loan and a withdrawal. One of them is a much better idea than the other.

Some employers set up their 401(k) accounts to allow employees to borrow a portion of their savings. The IRS will not allow anyone to take a loan that is more than 50% of the account balance. This type of loan is not taxed; the only time you’ll be taxed on the loan is if you default on payments. You will be charged interest until the balance is completely paid off. That interest goes back into the total savings, however, partially making up for the interest the money would have accrued if you had left it in the account.

The benefits of taking a loan on your 401(k) are that you can do so without a credit check and at a better interest rate than other short-term loan options. The downside is that you’ll technically be paying taxes twice since your “after tax” money will be used to pay yourself back into an account that will be taxed again once you retire. Defaulting on this type of loan is very serious and will result in early withdrawal penalties. In addition, some plans do not allow you or your employer to continue contributing to your 401(k) while your loan is active.

If anyone under the age of 59 ½ attempts to make a withdrawal from a 401(k), the money will be subject to income taxes and a 10% penalty. There are hardship exceptions, but those only waive the penalty fee—not the income taxes. Early withdrawal should be your last resort after you’ve exhausted every other possible option to meet your basic expenses. According to Investopedia, “For a $10,000 withdrawal, when all taxes and penalties are paid, you will only receive approximately $6,300.” Is it worth losing 37% of your nest egg to make an early withdrawal?

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