Given recent world events, this is a question faced by an increasing number of people. What to do with this retirement account is an important financial decision, and not one to be made lightly.
Whether the separation is voluntary or not, when you leave a job where you have a 401(k) you have four options regarding that retirement account: leave it where it is; roll it over into a 401(k) with a new employer; roll it into an IRA; cash it out. If you do not have a new employer, or you do but they do not offer a 401(k), the second choice is not an option. Since this article will primarily look at investment vehicle choices, we will imagine that you are not interested in cashing out your 401(k) at this time.
However, if your balance is under $5,000, the plan administrator may attempt to make the choice for you. Unless you provide guidance as to where you would like the funds to be rolled over, the plan will send you a check if your balance is under $1,000. Similarly, if your balance is between $1,000 and $5,000 the plan may choose to remove you from the 401(k). They should ask you for your preferred distribution option. If you do not respond, the plan administrator can move your account balance into an IRA. You will then need to make investment choices, as this will not happen automatically.
If your balance is over $5,000 that leaves two options; keep the funds in a 401(k), or move them into an IRA. There is no one correct answer for everyone. The best choice for you will depend on a variety of factors, and should be made after careful consideration and preferably after consultation with your financial advisor. Let us look at the advantages of both choices.
Leave the Money in Your 401(k)
Among the advantages of choosing this option is the relative ease of withdrawing funds pre-retirement. While ideally this would not happen, there may be occasions where it is necessary. Taking money from an IRA can be difficult, and may involve a ten percent penalty in addition to the twenty percent withheld for taxes. For example, if you wanted to have $10,000 available, you would need to take out $13,000 to cover the penalty and taxes. There are some exceptions to the ten percent penalty, including some educational costs, health care expenses, and to buy a first home.
If you need the funds, it may be preferable to take out a loan from your 401(k) instead. In this case, you are in essence loaning money to yourself, and paying yourself back with interest. While there are limits to the amount that can be accessed in this manner, as long as payments are made there are no penalties or tax concerns. In addition, you will not be permanently depleting your retirement account.
If you leave your job during or after the year in which you turn 55, you can take money out of your 401(k) without paying the ten percent early withdrawal penalty. With few exceptions, funds cannot be removed from an IRA before you are 59 ½ without penalty. This may be a factor for younger workers leaving a job if they believe they may need access to the funds before retirement.
Generally speaking, investment fees and expenses will be lower in a 401(k) than an IRA. While this is not always true, and it certainly pays to compare, lower fees can be an advantage of a 401(k) over an IRA.
A 401(k) can potentially offer superior asset protection as well. Creditors are typically prohibited from seizing 401(k) assets. There are exceptions. The IRS can go after your 401(k) to collect taxes owed, and if you owe alimony or child support your 401(k) can be accessed by way of a qualified domestic relations order.
Assets in your 401(k) are protected in a bankruptcy proceeding. Assets in an IRA or Roth IRA are protected up to $1,362,800 (adjusted for inflation every three years). However, protection from other judgments will depend on state law.
Rollover the Account into an IRA
The principle advantage of an IRA compared to a 401(k) is the vastly superior number of investment options that you have to choose from. A 401(k) typically has a limited number of mutual funds available, perhaps only ten or so. As such, small and mid-cap stocks are usually heavily underrepresented among the offerings. Investment choices for an IRA, on the other hand, could number in the thousands. If the investment options in your 401(k) are not meeting your needs, a rollover to an IRA may be to your advantage.
You may desire more investment options but be leery of making those choices yourself. If so, rolling over your 401(k) to an IRA may again be to your benefit. An IRA would offer the opportunity for professional management of your account. While some 401(k)s offer managed accounts, they are not plentiful. It is even possible that a professionally managed account could save you money on fees and expenses.
If you have reached retirement age and are ready to begin withdrawing funds from your account, an IRA may give you more flexibility than a 401(k). Most 401(k)s are not designed for consistent withdrawals and the paperwork can be tedious.
A 401(k) plan may permit only a limited number of withdrawals, perhaps annually or quarterly. Some permit systematic withdrawals only for required minimum distributions. While most plans would permit you to specify which investments to sell when you take a distribution, the default option would be for the withdrawal to occur on a pro rata basis; an equal portion of the amount would be taken from each investment in the plan.
If liquidity and ease of access to funds is important, an IRA may be the better option for you. Of course, you should consult with your financial advisor before making this important investment decision.