What Are Your Options with Your 401(k) Plan at Retirement or a Career Change?

Over the last several decades, there has been a significant shift toward 401(k) and other defined contribution plans, while defined benefit plans such as pensions have become less common for businesses to offer.

While pension plans can be a great option for employees who are able to obtain them, defined contribution plans such as a 401(k) also have advantages, including increased flexibility and portability between jobs.

However, a common question that often arises for those with a 401(k) plan is:
What should I do with the account at my previous employer?
Or, what are my options with the account when it’s time to retire?

There are often many misconceptions surrounding these accounts, and the correct decision is unique to each individual situation.

Common Features of 401(k) Plans

Here are some common features found in qualified defined contribution plans that are relevant when deciding what to do with an account.

Most 401(k) plans allow participants to make either pretax or post-tax (Roth) contributions. Employers may also contribute, typically with pretax dollars, depending on the structure of the plan. The recordkeeping platform that holds the funds keeps track of which portion of the account is pretax or post-tax, as these amounts are important when taking a rollover or distribution from the account.

A standard 401(k) plan typically offers participants a diversified selection of investment funds, although participants generally only have access to the limited menu of options offered within the plan.

Another important distinction of 401(k) plans is that assets within the plan are generally protected from creditors, including in bankruptcy. This can be an important consideration for individuals with significant liability exposure.

Funds can generally be withdrawn from a 401(k) without penalty at age 59½, or as early as age 55 if the participant separates from service during or after the year they turn 55. This “age 55 rule” is unique to employer retirement plans and does not apply to IRAs.

Loans can also be taken from many 401(k) plans, typically up to 50% of the account balance (up to $50,000), although loans must be repaid with interest and may become taxable if not repaid according to plan rules.

Required Minimum Distributions (RMDs) from a traditional 401(k) can often be delayed if the participant continues working, provided they are not more than a 5% owner of the company.

Required Minimum Distributions (RMDs) do not have to be taken from a traditional 401(k) plan as long as the participant continues to work, provided they aren’t more than a 5% owner in the company.

Participant Options for Their 401(k)

1. Leave in Prior Employers Plan

The simplest, although the least often recommended option, is to leave the account with the prior employer (assuming the plan allows it). 

Some disadvantages include the lack of oversight and coordination with your broader financial plan. Investment allocations may go unmonitored, and it can be easy to forget about the account as time goes on.

For many investors, it may make more sense to roll the account into either an IRA or a new employer’s 401(k) plan.

2. Rollover into an Individual Retirement Arrangement (IRA)

A popular option when retiring or changing jobs is to roll the assets directly into an IRA.

A Traditional or Roth IRA can be established to receive the transfer. If executed properly as a direct rollover or trustee-to-trustee transfer, there are no immediate tax consequences.

However, if the funds are made payable directly to the participant first, the plan is required to withhold 20% for federal taxes, even if the participant intends to complete a rollover.

Advantages of Rolling into an IRA

One advantage of an IRA is greater investment flexibility. IRAs generally offer a much wider range of investment options than a typical 401(k) plan.

Another advantage is control. The account owner has full authority over the account and can evaluate strategies such as Roth conversions or other tax-planning opportunities.

Over time, it is common for investors to consolidate multiple retirement accounts into a single IRA for simplicity and coordination.

Opening and funding a Roth IRA through a conversion can also begin the five-year clock required for tax-free Roth withdrawals.

Potential Disadvantages

While rolling a 401(k) into an IRA is often appropriate, there are some potential drawbacks to consider.

First, creditor protection may be reduced. While IRAs do provide some federal and state protections, they are generally not as strong as ERISA-protected employer plans.

Second, Required Minimum Distributions must be taken from traditional IRAs beginning at the required age, even if the individual continues working.

Finally, IRAs do not allow the age-55 separation-from-service exception, meaning withdrawals before age 59½ may be subject to a 10% early withdrawal penalty unless another exception applies.

3. Rollover into a Current Employer’s Plan

Participants who have changed jobs and now participate in a new employer’s 401(k) plan may also have the option to roll their old account into the new plan, provided the new plan accepts rollovers.

The advantages include consolidation and simplification, keeping retirement savings in a single workplace plan.

As mentioned earlier, employer plans also typically offer stronger creditor protection than IRAs.

Additional potential advantages include:

• The ability to delay RMDs while continuing to work
• Access to the age-55 separation-from-service rule

4. Cash Out the Account Value

Another option is to simply cash out the retirement account. However, depending on the type of contributions and the participant’s age, doing so may result in ordinary income taxes as well as a 10% early withdrawal penalty.

For those under age 59½, withdrawals are generally subject to the 10% penalty unless an exception applies.

In most situations, cashing out a retirement account is not recommended, as it removes funds from a tax-advantaged account designed for long-term retirement savings. Allowing investments to remain in the market gives the compounding nature of long-term investing time to work in the participant’s favor.

Planning Considerations

The decision of what to do with an employer-provided retirement plan is an important one. The correct choice often depends on an individual’s career timeline, financial situation, and investment strategy.

At WSG, we help guide retirees and pre-retirees in making thoughtful, confident decisions as they move toward retirement.

In many cases, the decision itself is relatively straightforward, it simply requires the proper understanding of the available options.

As always, it is important to work with a financial professional when making decisions about retirement accounts, as taxes and penalties can apply if rollovers are executed incorrectly.

- Bill Rautiola, RICP ^®, AIF ^®, PPC ^®

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.