If you’ve lost your job, or are changing jobs, you may be wondering what to do with your 401(k) plan account. It’s important to understand your options.
What will I be entitled to?
If you leave your job (voluntarily or involuntarily), you’ll be entitled to a distribution of your vested balance. Your vested balance always includes your own contributions (pretax, after-tax, and Roth), and any investment earnings on those amounts. It also includes employer contributions and earnings that have satisfied your plan’s vesting schedule. In general, you must be 100% vested in employer contributions after 3 years of service (“cliff vesting”), or you must gradually vest 20% per year until you’re fully vested after 6 years (“graded vesting”). Some plans have 100% immediate vesting. You’ll also be 100% vested if you’ve reached your plan’s normal retirement age.
Special vesting rules apply to certain plans, so make sure you understand how your particular plan’s vesting schedule works. This is important, because you’ll forfeit any employer contributions that haven’t vested by the time you leave your job. If you’re on the cusp of vesting, it may make sense to wait a bit before leaving, if you have that option.
Don’t spend it, roll it!
While this pool of dollars may look attractive, don’t spend it unless you absolutely need to. If you take a full distribution you’ll be taxed, at ordinary income tax rates, on the entire value of your account except for any after-tax or Roth 401(k) contributions you’ve made. And, if you’re not yet age 55, an additional 10% penalty may also apply to the taxable portion of your payout. (Because of the 5-year holding period requirement, there won’t be any tax-free qualified distributions from Roth 401(k) accounts until 2011 at the earliest. And special rules may apply if you receive a lump-sum distribution and you were born before 1936, or if the lump sum includes employer stock.)
If your vested balance is more than $5,000, you can leave your money in your employer’s plan until you reach normal retirement age. In some cases, however, your best bet will be to roll the funds over to an IRA. It really depends on the investment options in your old employer’s plan, the fees, and how many other prior employer’s plans you still have money in. Consolidating 401(k) balances from multiple former employers can make it much easier to maintain your desired asset allocation, keep costs low, and reduce paperwork for you.
Your employer must allow you to make a direct rollover to an IRA. As the name suggests, in a direct rollover the money passes directly from your 401(k) plan account to your IRA. This is preferable to a “60-day rollover”–where you get the funds and then roll them over to an IRA yourself–because your employer has to withhold 20% of the taxable portion of a 60-day rollover. You can still roll over the entire amount of your distribution, but you’ll need to come up with the 20% that’s been withheld from other funds until you recapture that amount when you file your income tax return.
If you really do need to use some of the money, and you have nontaxable after-tax or Roth contributions in your account, keep in mind that you may be able to roll over the taxable portion of your distribution to an IRA, and take a distribution of just the nontaxable portion of your account. Again, avoid using retirement plan savings if at all possible. It can do permanent damage to your retirement funding, and it’s really hard to catch back up!
What if I have an outstanding plan loan?
In general, if you have an outstanding plan loan, you’ll need to pay it back, or the outstanding balance will be taxed as if it had been distributed to you in cash. If you can’t pay the loan back before you leave, you’ll still have 60 days to roll over the amount that’s been treated as a distribution to your IRA. Of course, you’ll need to come up with the dollars from other sources.