Written by: Jeff Standish
You have just decided to change companies, or you just got laid off. The last thing you are probably thinking about is what to do with that former (soon to be) employer’s retirement plan (401k/403b/457) you have been contributing to. Well, it is time to start thinking about it. You have choices! Most plans will allow you to keep it where it is. You can convert it to a rollover IRA. Or you can move it into your new employer’s retirement plan. In a pinch, you can access that money to get you through until a new job comes along, but this would be a last resort. When I recently moved employers, I had not thought about 1 big thing, and that is, was I fully vested to receive all of my company’s matching contributions? Some employers will match a percentage of your pay. Still, you cannot take that money with you if you leave if you have not met a certain vesting schedule (i.e., been employed there a certain amount of time)—something to think about if you are voluntarily moving from one company to another.
Each employer’s plan is different. Some employers will place a vesting schedule on any contributions they make to your retirement savings. For example, a company could say that if you leave for any reason in the first 3 years of employment, you can not keep any of their matching contributions. This should be something to look at if you are looking to move companies voluntarily. This could mean leaving a large amount of “free” money on the table. Each employer is different, and you would need to do a little research on your company’s policy.
Leaving the Money in the Old Retirement Plan
The easiest option would be to keep your retirement savings invested with your previous employer. You might do this if you really like the investment options, the fees are low, or maybe you don’t have anywhere else to move the money yet. All good reasons, and there is nothing wrong with any of them. Typically, if you have over $5,000 in an old retirement account, they will let you keep the money invested there. To make changes or to access the money in retirement, you will have to deal with your previous employer, and that potentially could be a bit of a hassle.
Some retirement savings plans have a provision that if you have more than $1,000 in your account, but not $5,000, you have up to 90 days after leaving the company to do something with your money, or they will automatically move that money over into a “Rollover IRA.” You could even end up having to pay fees and expenses for this. Then if you move that money again, there could be more transfer fees. Be sure you read the paperwork that HR sends you when you are leaving your former employer.
If you have under $1,000, your old employer may elect to just pay you a lump sum (minus mandatory 20% withholding for federal taxes) with in 90 days of leaving unless you elect to directly roll over the funds to your new employer’s eligible retirement plan or an IRA you have established. You will have to check with your new plan or IRA provider to make sure they will accept a rollover.
Direct vs. Indirect Retirement Plan Rollovers
When electing to move that (now prior employer) retirement savings plan money, you have a couple of options. You can do either an indirect rollover or a direct rollover. There are several reasons why the direct rollover is a much better option.
The indirect rollover is a distribution in your name directly to you. You have 60 days from the original distribution to deposit that money into an IRA or eligible retirement plan. If you wait more than 60 days to complete your rollover, you will be taxed at the full value of your distribution. Also, your previous employer’s retirement plan is required to withhold 20% of the distribution for federal income taxes. To postpone taxes on the full value of the original amount distributed in your name, you must rollover 100% of the account value before the 20% withholding. For example, if your plan had $100,000 in it, if you got an indirect rollover, the previous employer plan must withhold $20,000. You must come up with $20,000 to deposit $100,000 into the IRA or eligible retirement plan. If you do not have that extra $20,000, the money withheld becomes taxable income (and is subject to a 10% early withdrawal penalty if under age 59.5).
Make sure you’re doing proper tax planning in this scenario.
Would your employer send the funds directly to the trustee or custodian of your IRA or eligible retirement plan. With a direct rollover, You never see or touch the money. No taxes are withheld on the direct rollover. Clean and efficient.
When you roll over your old employer plan into a Rollover IRA, depending on who you transfer it to, you may have many more options for investments than you had access to at your old employer. Rolling the funds over also could allow you to better diversify your holdings. Some companies do their match in company stock. This could expose you to undo risk in one company.
Depending on your financial situation, this might also be a good time to convert some of that pre-tax money into a Roth IRA account. You must pay taxes on any money you convert, but this could be an ideal time to convert some of your pre-tax accounts to Roth accounts if you are in a lower tax bracket.
Until recently, I had 3 or 4 different old retirement accounts that I finally consolidated into one rollover IRA. It makes it a lot easier to check in once or twice a year—no need to obsess over the day-to-day fluctuations of your retirement account. I'm just looking to get a decent avg return over a long period of time that is consistent with my retirement time horizon.
Penalties for Early Withdrawals
At the other end of the spectrum, let’s say times are really tough and you think you might need to dip into that retirement money. Think of this as last resort money. There are some severe penalties for dipping into this money.
If you take a distribution from an IRA or 401k before age 59 1/2, you will likely owe both federal income tax and a 10% penalty on the amount that you withdraw, in addition to any applicable state income taxes. Taking money from this source would be the last resort for sure!
There are a few scenarios for penalty-free withdrawals from an IRA. You still must pay the income tax, just no 10% penalty. You may take an IRA distribution for qualified higher education. You may also use this exception against the penalty for yourself, your spouse, and your children. Tuition, books, fees, and supplies could all be paid for. First-time home purchases would also qualify for a distribution from an IRA without the 10% penalty. Lastly, unreimbursed medical expenses that are greater than 10% of your adjusted gross income in a year would qualify for a distribution from your IRA without the 10% penalty. Keep in mind that you still must pay income tax on these distributions, which only applies to an IRA. Each 401k has its own rules for hardship withdrawals. With many 401k’s, you could avoid the 10% tax penalty, but still get hit with a 10% penalty from the administrator of the 401k.
Keep in mind, even if you make a penalty-free withdrawal, that’s money you can’t add back into the account at a later date. There are limits to how much you can contribute to retirement plans each year, so it’s advisable to leave the money in there to compound and grow for retirement hopefully. Any withdrawals will stunt the potential growth indefinitely. Hence why we consider it a last resort.
To bring this all back around. When you leave a job, you can leave the money in your current retirement plan. Most likely, you will do this for a short amount of time while you transition to the next thing. Once you (hopefully) land on your feet, now you need to decide, do I just leave my money where it is? Do I open a rollover IRA or add it to an already existing rollover IRA? Do I move it to my new employer’s retirement plan? All the above options have their own pluses and minuses. Just make sure you keep track of where your money is and do not let it languish.