One of subjects that seems to come up when doing people's taxes and I see that they have changed jobs that had retirement plans is: What did you do with your retirement plan at your previous employer?
I have also found it amazing how many people have not even thought about it, or know what their options are. So, here is a short primer on your options.
#1 - 401(k) rollover: Keep you savings with your previous employer's plan
Of course, there are considerations if you want to keep your money in your previous employer’s plan:
- The size of your account. If you have less than $5,000 in your former employer’s 401(k) plan, require you to transfer the money out. Chances are that if you have less than $1,000 in the account, they will likely cut you a check for the appropriate amount. (I've also seen checks written for close to $100,000 to close out a former employer account.). If that happens, most people don't know about the 60 day rule to keep the funds non-taxable.
Here it is: You will need to deposit the check into your new employer's 401(k) plan or into a Traditional IRA within 60 days of receiving it to avoid paying taxes on the money and, if you’re under 59 ½, a 10% early-withdrawal penalty. - Employer stock. If your account includes publicly traded stock in your former company and that stock has grown a lot in value, then the tax breaks you received from the in-kind distributions of the stock will be lost if you take the option to roll over your account into your new employer’s 401(k) plan or your IRA.
- Vesting. If your previous employer contributes matching funds to your 401(k), the money usually vests over time. So, if you're not fully vested when you leave the employer, then you will get to keep only a portion of the match–or none at all. Make sure you understand your former company’s vesting schedule.
- Fees. A 401(k) account is a convenient way to put away money for retirement, but is amazing how many people don't look at the maintenance and transaction fees that are charged . As you evaluate options, make sure you understand exactly how much you’re paying in fees where you are at and where are thinking of going.
#2 - 401(k) rollover: Moving the money from your former into your new employer's plan
If you want to move your old 401(k) after changing jobs and into your new employer’s qualified retirement plan, there are some things you should consider. The new plan may have lower fees or investment options or rolling over your old 401(k) into your new company’s plan can also make it easier to track your retirement savings, since you’ll have everything located in one place.
Here are some things you need to think about:
- Direct rollovers. This gives you the option to transfer funds from your old plan directly into your new employer’s 401(k) plan without incurring taxes or penalties. You then work with your new employer’s plan administrator to select how to allocate your savings into their investment options.
- Transfer rules. As mentioned above, failure to follow 401(k) transfer rules could result in extra penalties and taxes. For example, if you don’t do a direct rollover and receive the funds from your previous employer’s plan in the form of a check, a mandatory 20% withholding will normally apply. And remember, if you don’t deposit the check within 60 days of receiving it and are under the age of 59 ½, you’ll get hit with a 10% early-withdrawal penalty on top of any taxes. (It's never fun to see that surprise balance due when you do your taxes.)
- Loans. There are some retirement plans that allow you to borrow money from your 401(k). If you roll over your old plan into your new plan, you may have a larger balance to borrow against. You will have to pay yourself back, with interest, over time, and the loans are usually only an option for active employees. On the other hand, if you have a loan outstanding on the former employers plan, they will use the funds to pay that off first before the transfer, which will become taxable income to you on your next tax return.
#3 - 401(k) rollover: Rolling your old 401(k) into an individual retirement account (IRA)
This is a popular option for people that tend to move between jobs more often or their new employer does not offer a good retirement option. An IRA rollover also gives you access to a wider range of investment options, since you’ll be in control of your retirement savings rather than having to choose what the new employer may have to offer. Depending on your investments, a rollover may also save you money from management and administrative fees.
Which type of IRA you rollover your 401(k) into has different tax implications that you should consider:
- Traditional IRA rollover. Rolling over your old 401(k) account to a traditional IRA means no taxes will be due when you move the money, and any new earnings will accumulate tax deferred. You'll only pay taxes when you take withdrawals, normally after age 59 1/2 so you don't have to pay that nasty 10% penalty.
- Roth conversion. If you qualify, you can roll over all or part of your old 401(k) directly to a Roth IRA. Converting a traditional 401(k) to a Roth IRA is like to rolling over your 401(k) to a traditional IRA, but with one big difference - You will have to pay taxes on the money you convert. This is because Roth retirement accounts are funded with dollars you've already paid taxes on, while traditional 401(k)s are funded with pre-tax dollars. What makes Roth IRAs so popular is that after you pay the tax on the conversion, any money that it makes after that will be tax free, as long as your Roth IRA has been open at least five years and you are at least 59 ½ years old.
- Roll over your Roth 401(k) to Roth IRA. While a traditional 401(k) is funded with pretax dollars, a Roth 401(k) is funded with after-tax money like a regular Roth IRA. And when you roll over a Roth 401(k) to a Roth IRA, no taxes are due when the money is moved, and any new earnings accumulate tax free if certain conditions are met. Again, earnings are eligible for tax-free withdrawal once the Roth IRA has been open at least five years and you reach age 59 ½.
Here are some additional considerations to think about:
- Contribution limits don’t apply to rollovers. In 2024, IRAs have an annual contribution limit of $7,000, however, there is no limit on funds that come from a 401(k) rollover. Even if you have a large amount of money in your 401(k), you can roll over all of it into a traditional IRA.
- Taxes. When you do a Roth conversion, you could end up owing a lot of money to the IRS for your conversion year, because the amount that's converted is included as taxable income on your tax return.
- Required minimum distributions (RMD). If you’re still working at a certain age, you’ll be required to start taking minimum distributions from your IRA, and the penalty for not taking those payments is 25% of the amount you should have taken out. Ouch! By comparison, a Roth IRA has no required minimum distributions during the account owner's lifetime. (The current RMD age is 73.)
#4 - Just Cash out your old 401(k)
Unsure what to do with an old 401(k)? You can always just cash it out for, well, cash. But consider this. The cash you take out is considered income, and you could have to pay local, state and federal taxes on it. And, if you leave your employer prior to the year you turn 55 and are younger than 59 ½, you will be required to pay a 10% early withdrawal penalty on top of any taxes on the money!
So there you have it. Four ways to deal with those 401s that may be laying around. And you probably now know more than most about retirement plan rollovers.