If you’ve recently left your job to start a new chapter in life, you may be wondering what to do with your old 401(k) account. Regardless of how much money you’ve accumulated in your account, you’ll need to decide what you want to do with that money next — leave it where it is, move it to your new 401(k), roll it over to an IRA (individual retirement account), or cash it out.
There are reasons each of these options might be a good idea, and your decision shouldn’t be taken lightly. What you do with this money is an important part of saving for retirement and tax planning so it’s best to fully understand your options and which move is best for you.
Let’s walk through each of the different choices you have and why you might (or might not) want to go each route.
Leave your money in your old 401(k)
Your first thought might be to just leave your money where it is. It’s already invested, maybe your investments are doing well, and it’s easier to leave it alone. Although this is possible under some plans, it’s not an option for everyone — nor is it always the best choice.
You may decide to leave your 401(k) with your previous employer if the plan has good investment options and low fees. The lineup of investment choices might be exactly what you want, and if you’re able to stick with them, why go through the process of moving your money to a new retirement account?
If you hope to leave your 401(k) where it is, your account needs to have a value of at least $5,000. If your account balance is below $5,000, your former employer can actually force you out of the plan without your consent. And they can do this immediately upon you leaving the company.
If you have more than $1,000 at the time of the distribution, your former employer must automatically move your money into an IRA of their choosing. The IRA they choose might come with higher fees and costs than your old 401(k), so you’ll need to act swiftly after leaving your company and tell them whether you’d rather receive a lump sum distribution payment or move that money into an IRA you choose.
Additionally, because you’re no longer an employee of your old company, you might miss out on important information about plan changes and investment options if you leave your money where it is. You will also no longer be able to contribute to your former employer’s 401(k) plan.
Move your money to your new 401(k)
With a new employer, you’ll likely have a different list of investments to choose from. If the new job’s plan offers better options and lower costs, moving your money to your new employer’s 401(k) plan might be a good move. Just make sure your new plan administrator accepts a rollover, as not all will.
Moving your 401(k) into a new employer’s plan allows your money to continue to grow tax-deferred. You will only have to pay taxes on contributions and earnings when you begin taking distributions in retirement.
Alternatively, your new company may offer a Roth 401(k). With a Roth 401(k), your contributions are made with after-tax dollars. Therefore, your distributions are not taxed in retirement. If your new employer offers this conversion and you choose to roll over a traditional 401(k) to a Roth 401(k), you will have to pay taxes on the amount you convert upfront.
Moving your money to your new 401(k) will also make it easier to manage your retirement savings. If you have jumped around from job to job and have a trail of old 401(k) accounts, consolidating them into one new plan might be a good idea.
Roll over your 401(k) to an IRA
If you want to move your money into a new account while maintaining its tax advantages, another option is to do a rollover IRA. When you roll over money from a 401(k) into an IRA, you’re able to maintain the tax-deferred growth as you generally won’t pay taxes on that money until you withdraw it from the new plan. You can also choose to convert your 401(k) into a Roth IRA at this point, but you will have to pay taxes on the converted amount upfront just as you would a Roth 401(k).
Compared to a 401(k), IRAs typically have more investment options. A 401(k) plan usually has a handful of mutual funds, bonds funds, and exchange-traded funds, whereas an IRA opens the door to most investment options, including stocks in individual companies. With more choices, there’s a good chance you’ll be able to find lower fees and costs on your investments as well.
If you choose to roll over your 401(k) into an IRA, you’ll need to decide which financial institution you will open your IRA with. If you want full control and to choose your own investments, opening an IRA with an online broker like TD Ameritrade or Charles Schwab is a good option. Your funds will transfer into your new IRA account as cash, and you can choose how to invest it.
If you prefer to have your investment managed for you, a company like Betterment may be a better option. With no minimum balance and just a .25% annual advisory fee, moving your old 401(k) to Betterment could save you money. The rollover process is quick and easy, and you’ll be able to pick the kind of investment portfolio that best matches your needs. Plus, right now you can get up to one year free of management fees when you sign up with Betterment and complete your rollover within 45 days.
One word of caution on this strategy
You might not want to roll over your entire 401(k) into an IRA if your 401(k) has company stock that has greatly increased in value. Something called net unrealized appreciation is the difference between what you paid for a stock and its current market value. If you roll over this stock to an IRA or take a cash payment, the entire amount of the distribution will be taxed at your ordinary income tax rate (the same rate at which your regular income is taxed).
If you instead distribute the stock to a taxable brokerage account, you will pay taxes only on the original value of the stock. You will pay the long-term capital gains tax rate on the NUA only when you sell the stock in the future.
So what’s a taxable brokerage account? It’s similar to a retirement account, like a 401(k) or IRA, in that you can purchase stocks, mutual funds, and other assets. The difference is that there are no tax benefits. An example of a taxable brokerage account is an account you would open with Robinhood or TD Ameritrade to trade stocks or other funds.
Take distributions from your 401(k)
Perhaps the new chapter in your life is not that you recently started a new job but rather that you’re ready to start using your retirement savings. If that’s you, you can start taking distributions from any 401(k) without penalty after age 59 1/2. With traditional 401(k) accounts, you will pay taxes when you withdraw your money. The effective tax rate will be your regular tax rate at the time of the distribution.
If you have a Roth 401(k), your contributions were made with after-tax dollars. That also means any income you earned on the account is tax-free. This includes any interest, dividends, and capital gains you’ve accumulated. To begin withdrawing from a Roth 401(k), you must have held your account for five years. After five years, your distributions are considered qualified and can be taken tax-free. This rule applies even if you’ve reached age 59 1/2.
Cash out your 401(k)
If you no longer want your money to go toward your retirement and just prefer to spend the money as you please, you may decide to cash out your 401(k) account. This option can be enticing, especially if you’re thinking about using your 401(k) to pay off debt. In uncertain financial times like we’re seeing today, this might seem appropriate. But before you cash out your retirement money, you need to be aware of the consequences.
By cashing out your 401(k), you not only sacrifice your retirement by missing out on years of compound growth. The stock market has historically averaged returns of nearly 10% before inflation, and by taking your money out of the game you lose your chance at those gains.
And, unless an exception applies, you will also be hit with a 10% early withdrawal penalty, in addition to income tax, if you’re under the age of 59 1/2 when you take the cash distribution. For example, if you earn more than $44,725 a year in 2023 ($89,450 for those who are married and filing jointly) and are in the 22% federal income tax bracket, a $5,000 early withdrawal from your 401(k) will cost you $1,600 in taxes and penalties.
More on rollovers
When you roll over funds from a retirement plan, you have 60 days from the distribution date to put the funds into another retirement plan or IRA to avoid taxes and penalties. Any amount that isn’t deposited into the IRA within that time will be taxed as a withdrawal. And if you’re under the age of 59 1/2, you will have to pay that 10% early withdrawal penalty as well.
There are two ways you can roll over your old 401(k) into a new retirement account: you can have the distribution paid to you (this is called an indirect rollover) or have your plan transfer the payment straight to the new account (this is called a direct rollover). Choosing a direct rollover is the easiest way to transfer funds, and eliminates the risk of getting caught up in paying taxes.
If you’ve recently left your job and are wondering what to do with your old 401(k) account, you have a lot of options. How well these options fit into your personal finance needs will depend on your specific situation, but it’s a good idea to familiarize yourself with the different choices. Weigh the pros and cons of each to help you determine what’s right for you.
If you have questions about the options available to you or feel that your situation is more complex, you’re best off speaking with a financial advisor and/or someone who can help you formulate a winning tax strategy. These professionals can look at your situation and provide guidance as to which path will work best for you.