When a 401(k) participant is changing a job, they can either leave their retirement savings with former employer or rollover into a different plan. If doing the latter, they have a variety of options for how to handle this situation, but there are limitations they should be aware of. For instance, things are very different for those who are over the age of 59 ½ years as opposed to those who are younger. Here’s an overview of distribution options and how different circumstances affect how much of a participant’s money they can hold on to as they change employers.
Leaving the Funds Where They Are
A participant can always leave their money in their former employer’s 401(k) plan. This makes sense when that plan has a diversified investment menu and low-cost investment funds, preferably index funds. If that plan is working well for the participant, there is essentially no reason to move those funds. In most cases, as a retirement plan sponsor, you want to keep your departing employee’s assets because the more assets in a plan, the more negotiating power you have with third-party service providers.
Withdrawing All of It
The option is always available to simply take out all of the funds in cash, but there are strict rules about that. If the participant is under the age of 59 ½ years, the penalty for premature withdrawal is 10% of the total that they are withdrawing. If they are over 59 ½ years old, they can withdraw their funds without that penalty.
But no matter what age they are, if they cash out, their distribution will be subject to a mandatory 20% withholding. For example, if a participant is under the age of 59 ½ years and she cashes out $10,000, she might walk away with only $8,000. Taking into account federal and state income taxes, the total amount would be even less.
Separation After Age 55
If a participant separates from service at your organization after age 55, you can make a distribution to them without the 10% early penalty. This rule applies only to defined contribution plans.
Another way for your participants to avoid the 10% early distribution penalty is for them to take substantially equal periodic payments over the life expectancy of the participant or his/her designated beneficiary. However, there is a catch to this rule. The participant or the beneficiary must separate from service and not make any modifications to the substantially equal periodic payments for at least five years. Otherwise, a 10% penalty will be applied on all waived amounts, plus interest for the deferral period.
Rolling it Over Into the New Employer’s Plan
A participant can also roll over their 401(k) funds, if their new employer allows that. Rolling over means transferring the money to another plan without withdrawing anything. When the funds get rolled over from the previous employer’s plan to the current employer’s plan, there are no penalties or taxes because the participant is not converting any of the funds to cash. Rolling over 401(k) funds into the current employer’s plan can be done at any time, not just when the participant takes the new job.
Rolling it Over Into an IRA
401(k) participants can also roll their funds over into an individual retirement account (IRA). The advantage of an IRA is that they have more investment options and can tailor their investments to fit their stage of life, risk preferences, and goals. They can choose from anything that is traded on the stock market: individual stocks, bonds, index funds, real estate investment trusts (REIT’s), etc.
If the participant rolls over their funds into an IRA there are no penalties or taxes taken out.
Separating from Service With an Outstanding Loan
Maybe a participant had to borrow money from their 401(k) account and still owes the balance. In this case, they might want to leave their account with the previous employer until they pay off the loan. If they default on the loan, the amount of their loan will be treated as an early withdrawal and the IRS will impose the 10% penalty and the taxes due on the amount.
A participant can also cash out with a loan which means they convert their 401(k) funds into a cash withdrawal, less the penalty and taxes on the overall account balance plus the amount of the loan.
One thing a participant cannot do is rollover the loan into their new employer’s 401(k) plan or into an IRA. The IRS does not allow this and if the participant tries to do it they will pay the 10% penalty and taxes on the loan amount.
Over the Age of 59 1/2
When a separating from service employee turns age 59 ½ , he or she can finally tap into their retirement funds without paying the 10% early distribution penalty. Of course they would still owe taxes based on the ordinary income tax rate at the year of distribution. Roth 401(k) and Roth IRA accounts are not subject to taxes.
In terms of available distribution options, your employees essentially have the same options:
Cash out with 20% withheld for taxes
Rollover into an IRA
Rollover into a new employer's retirement plan
Annuitize their savings and receive monthly payment for life, if the plan provides access to annuities
Required Minimum Distributions (RMDs)
It is not uncommon to see participants working well into retirement. If this is the case, it is important to keep it mind that a participant who owns less than 5% of the company doesn’t have to take RMDs from their existing employer plan until he or she retires. However, this rule doesn’t apply to IRAs where RMDs must be taken out no matter what. The same is with the assets left with former employers' plans from which they have separated from service.
If the participant mistakenly assumes that there is no need to take RMDs from other plans when he or she becomes 70 ½ years old, the IRS may still impose the 50% penalty for the missed RMD.
Conclusion
Every 401(k) plan participant has four main distribution options: cash out, leave it untouched, roll it over into a new 401(k) plan, or roll it over into an IRA. Participants who are age 59 ½ and over can also choose distributions from their 401(k) accounts in the form of annuities or installments. Whichever they choose, it’s important for participants to keep records of all of their retirement plans so they don’t lose out on a single dollar to which they are entitled.