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Understanding 401(k) Transfers and Your Options

A 401(k) is a retirement savings plan that many employers offer to their workers. When you leave a job, you may have several choices about what to do with the money in that account. This guide provides information about the main transfer options available to people in this situation.

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According to the U.S. Department of Labor, approximately 55 million Americans participate in 401(k) plans. Many of these workers will change jobs during their careers and face decisions about their retirement savings. Understanding your options before making a move is important because different choices can have different tax consequences and long-term effects on your retirement savings.

The four main paths for a 401(k) when you leave employment are: rolling the money into an Individual Retirement Account (IRA), rolling it into a new employer's 401(k) plan, leaving it with your former employer, or withdrawing the money. Each option has different rules, costs, and potential tax implications.

This guide focuses on the factual information about each option so you can understand how they work. It does not provide personalized advice about which choice is right for your specific situation. Consider talking with a tax professional or financial advisor who can review your circumstances before you make a decision.

Practical Takeaway: Before moving forward with any 401(k) decision, take time to gather information about your current plan's rules and the options available to you. Request a summary of your account balance and any fees or restrictions that apply.

The Rollover to an IRA: What You Should Know

A rollover to an Individual Retirement Account (IRA) is one of the most common options when leaving a job. This means transferring money from your 401(k) directly into an IRA that you own. The IRS allows this type of transfer, and when done correctly, it does not trigger immediate taxes on the amount transferred.

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There are two main types of IRAs you can roll money into: Traditional and Roth. A Traditional IRA rollover keeps the tax-deferred treatment of your original 401(k) contributions. This means you do not pay income tax on the money until you withdraw it in retirement. A Roth IRA rollover converts your pre-tax 401(k) money into after-tax Roth money, which means you would owe taxes on the converted amount in the year of the rollover, but future withdrawals would be tax-free under certain conditions.

One key distinction involves direct rollovers versus indirect rollovers. A direct rollover happens when your 401(k) plan administrator sends the money straight to your IRA custodian. You never touch the funds, and there are no tax withholding requirements. An indirect rollover means you receive the check yourself and must deposit it into an IRA within 60 days. If you take more than 60 days, the IRS treats the withdrawal as a distribution, which means you may owe income tax and potentially a 10% penalty if you are under age 59½.

IRAs offer more investment choices than many 401(k) plans because you can select from thousands of mutual funds, stocks, bonds, and other investments. However, IRAs also typically have lower contribution limits than 401(k) plans. For 2024, you can contribute up to $7,000 per year to an IRA (or $8,000 if you are age 50 or older), whereas 401(k) contribution limits are much higher.

Another consideration is the pro-rata rule. If you have multiple Traditional IRAs or both Traditional and SEP IRAs, the IRS looks at all of them together when calculating taxes on a Roth conversion. This can affect how much tax you owe, so it is worth understanding before converting.

Practical Takeaway: Before rolling over to an IRA, compare the fees and investment options offered by different IRA providers. Request information about annual account maintenance fees, transaction costs, and the range of investments available. If you are considering a Roth conversion, calculate the tax impact in the year you make the rollover.

Rolling Over to a New Employer's 401(k) Plan

If your new employer offers a 401(k) plan, you may be able to roll your old 401(k) balance directly into it. This keeps your money in a 401(k) structure rather than moving it to an IRA. This option is sometimes overlooked, but it offers specific advantages for certain people.

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A direct rollover to your new employer's plan works similarly to an IRA rollover. Your former plan administrator transfers the money directly to your new employer's plan. You do not receive the funds, so there are no tax withholding complications. This is a straightforward transfer that typically takes a few weeks to complete.

One significant advantage of rolling to a new 401(k) is access to your money before retirement age without penalty in certain circumstances. 401(k) plans allow a feature called the Rule of 55 (or Separation from Service). If you leave your job during or after the year you turn 55, you may withdraw money from that employer's 401(k) without the usual 10% early withdrawal penalty, even before age 59½. This applies only to the 401(k) from the employer you just left, not to earlier 401(k)s or IRAs. This can be valuable for people who retire early or transition to part-time work.

Another advantage involves loan options. Many 401(k) plans allow you to borrow against your balance, though not all do. If you need access to cash, borrowing from a 401(k) might be an option, whereas IRAs do not allow loans. If your new employer's plan permits loans and you think you might need one, this could influence your decision.

However, 401(k) plans typically offer fewer investment choices than IRAs because the plan administrator selects which investments to include. You are limited to the menu of funds available in that specific plan. Additionally, 401(k) plans often charge higher fees than IRAs, though this varies by plan and provider.

Not all employers allow rollovers into their 401(k) plans, and some plans have waiting periods before you can participate. Check with your new employer's human resources department to learn about their specific rollover policies.

Practical Takeaway: If you roll into your new employer's 401(k), verify when you become investment-eligible (sometimes there is a waiting period) and request a complete fee schedule. Also, note the date you leave your job in case you may want to use the Rule of 55 for penalty-free withdrawals later.

Leaving Your Money in Your Former Employer's 401(k)

You have the option to simply leave your 401(k) money with your previous employer's plan, even after you leave the company. This is called leaving your balance in the plan or keeping it as a separated participant. While this might seem like doing nothing, it is actually a conscious choice with specific implications you should understand.

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The main advantage of leaving money in your old 401(k) is simplicity. You do not need to take any action, make investment decisions, or arrange a transfer. Your money stays invested according to your current allocation, and the plan administrator continues managing the account. If you are satisfied with the investment options and fees in your current plan, there may be no reason to move the money.

However, there are downsides to consider. First, you typically cannot add more money to a 401(k) after you leave that employer, even if the plan allows it. This limits your savings options if you want to continue contributing to a 401(k)-type plan. Second, many former employer plans do not allow you to change your investment choices or have limited options available to separated participants. You may be locked into your current allocations.

Third, some plans require you to maintain a minimum balance. If your 401(k) balance falls below the minimum (often around $5,000), the plan may force you to take a distribution or roll the money out. The specific rules vary by plan. Fourth, keeping multiple 401(k)s with different employers makes it harder to track your overall retirement savings and may increase paperwork and fees if each plan has annual maintenance costs.

There is also the "lost account" risk. If your address changes and you do not update your contact information with the plan administrator, you might miss important notices about plan changes or fee increases. Some accounts become lost or forgotten simply because the person