Changing jobs brings excitement and new opportunities. It’s also a time to consider your 401(k) and how your retirement savings fit into your financial future. Understanding tax implications is critical to making the right decision for your retirement plan.
There are various ways to handle a 401(k) when you switch employers. Each choice has tax consequences and rules that can significantly impact your finances. Before making any decisions, familiarize yourself with your options to maximize your retirement savings without falling into a tax trap.
Leave Your 401(k) With Your Former Employer
When you leave a job, you often can keep your 401(k) funds in your former employer’s plan. This choice may seem the easiest, but knowing its limitations is important.
Leaving your 401(k) with your old employer can allow your investments to grow, tax-deferred. However, some plans may limit your ability to take loans or distributions. Fees may also increase now that you’re no longer an active participant in the plan.
Keeping track of multiple retirement accounts also can become cumbersome as you move through your career.
It is critical to understand your plan’s rules and fees and how this option fits into your overall retirement strategy.
Rolling Over to Your New Employer’s 401(k) Plan
If your new employer offers a 401(k) plan, you can roll over your old 401(k) into the new plan. This option allows you to consolidate your retirement savings into one account, simplifying your investment management.
Before proceeding with a rollover, check if your new plan accepts rollovers from former 401(k) plans. Knowing the new plan’s investment options, fees, and features is also essential. A direct rollover – where your funds are transferred directly from your old 401(k) to your new one – allows you to avoid tax consequences.
With an indirect rollover, your plan administrator distributes the funds to you, and you’re responsible for depositing them into a new retirement account within 60 days. However, the administrator is required to withhold 20% for federal taxes.
If there’s no withholding, this means you must come up with 20% out-of-pocket to complete the rollover in full, or the shortfall will be treated as a taxable distribution. To avoid this issue, it’s generally best to opt for a direct rollover, which transfers the funds directly to the new plan or IRA without any withholding.
Rolling Over to an IRA
You also have the option to roll over your 401(k) to an Individual Retirement Account (IRA). This strategy provides access to a broader range of investment choices compared to most employer-sponsored 401(k) plans. IRAs offer the flexibility to choose from a wide variety of stocks, bonds, mutual funds, and other investment vehicles.
If not done correctly, rolling over to an IRA may have tax implications. Choosing a direct rollover into a traditional IRA ensures that your funds continue growing tax-deferred and avoid immediate tax consequences.
If you decide to roll your 401(k) into a Roth IRA, be prepared to pay taxes on the amount rolled over. A Roth IRA offers tax-free growth and tax-free withdrawals in retirement, but you must pay taxes up front. This option can be attractive if you’re in a lower tax bracket.
Before converting your 401(k) to a Roth IRA, carefully assess your current tax situation and future income needs.
Cashing Out Your 401(k)
While cashing out your 401(k) might seem tempting, especially if you’re facing financial challenges, it’s generally the least favorable option from a tax perspective. When you cash out your 401(k), the distribution is subject to federal and state income taxes. If you’re under age 59½, an additional 10% early withdrawal penalty will apply.
Cashing out reduces your retirement savings and can result in a significant tax bill. The added income might put you in a higher tax bracket, further increasing the tax consequences.
It is wise to consider your 401(k) as long-term savings and explore other financial resources before opting for a full cash-out.
Consider Potential Tax Penalties
If you’re between the ages of 55 and 59½, you may be able to take penalty-free distributions if you leave your job and meet certain conditions. This is known as the “Rule of 55,” which permits penalty-free access to your 401(k) if you retire, quit, or are laid off during or after the year you turn 55. Remember that this rule only applies to the 401(k) from the employer you left; any previous 401(k)s are not eligible unless rolled over into the current plan before leaving.
Required Minimum Distributions (RMDs)
Another tax factor to be aware of is Required Minimum Distributions (RMDs). Once you reach age 73, the IRS requires you to take minimum withdrawals from your traditional 401(k) or IRA each year. Failing to take RMDs on time can lead to a 25% excise tax on the amount not withdrawn, so it’s essential to be aware of these requirements as you approach retirement.
Final Thoughts
Moving your 401(k) to a new employer or account is an opportunity to review your retirement strategy. Each choice – leaving your 401(k) with your former employer, rolling it over to your new employer’s plan, rolling over to an IRA, or cashing out – has specific tax implications that require careful consideration. Understanding and aligning these implications with your financial goals will help you make the best decision for your future.
Consulting a financial advisor can provide clarity as you navigate these choices, helping you create a tailored plan that maximizes your retirement savings and minimizes your tax burden.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.