The ability to retire comfortably and confidently is one of the most common financial goals people have. You spend a lot of time and energy working to get there.

One of the ways people save toward retirement is by putting money into a 401k. These retirement plans are offered to workers through their employers.

Because 401k plans are connected to employers, you may wonder what you should do with your 401k after leaving your job. This is especially relevant right now, as more and more people are changing jobs in the middle of what’s being called “the Great Resignation.” 

According to a recent CNBC report, a record-high 4.4 million people quit their jobs in September 2021, bringing the annual total to 34.4 million. That’s in addition to the 36.3 million people who left their jobs in 2020.

Changing jobs can be truly exciting, but it can also be stressful. As you’re going down the list of things to think about before making a change, you want to make sure no stone is left unturned so that you can make the decision that’s best for you and your future. 

Knowing and understanding your 401k plan options can help make your transition into retirement or a new job smoother — without disrupting your retirement savings or financial plan.

What is a 401k?

A 401k is one of the most common retirement savings plans. Specifically, it is an employer-sponsored retirement plan. That means these plans are offered by and connected to your employer.

401k plans offer a number of retirement saving benefits, including:

  • 401ks usually have an employer match up to a certain percentage of your salary. For example, if your employer offers a 4% match, that means they will match your personal 401k contributions, up to 4% of your annual salary. So if your salary is $100,000 and you contribute at least $4,000 to your 401k, your employer would “match” that 4% by contributing an additional $4,000. This is essentially free money.
  • 401k savings are usually tax-deferred, which means you don’t pay income taxes on the money you save at the time of the contribution. Instead, you defer paying those taxes until you take the money from the 401k in retirement. This means you’ll have a lower tax burden now and more savings to put toward investments.
  • The annual contribution limit for 401ks is higher than most other retirement plans. For 2022, people under the age of 50 can contribute up to $20,500. If you’re 50 or older, you can contribute an additional $6,500 in catch-up contributions.
  • 401k contributions are automated and easily managed. There’s very little effort on your part when it comes to saving to a 401k.
  • Some 401k plans may offer custom investments that are not directly available with other retirement accounts.
  • Some 401k plans offer borrowing options with low interest rates.

What’s the difference between a 401k and IRA?

401ks and Individual Retirement Arrangements (IRAs) are both types of retirement accounts, and it’s not uncommon for people to have both as part of their retirement savings plan. 

That said, there are some key differences between them. Most notably, 401ks are employer-sponsored and usually have an employer match. IRAs are not connected to an employer. So job changes do not impact IRAs.

Additionally, the annual contribution limit is much higher for a 401k than an IRA. In 2022, individuals under the age of 50 can contribute $20,500 to a 401k but only $6,000 to an IRA.

The last major difference between the two retirement accounts is that 401ks usually have more limited investment options than IRAs. With an IRA, you have more control and flexibility over your investment choices, including the entire universe of investments — from stocks and bonds to mutual funds and ETFs. 

With a 401k, you are limited strictly to the investment options offered by the plan administrator. Those options change from plan to plan.

401ks and Traditional IRAs both offer tax-deferred growth. That means income taxes are not withheld from your contributions. Instead, you defer paying those taxes until you take money from your 401k as cash withdrawals (usually in retirement). 

Deferring the taxes allows you to save and invest more while working, adding to your compounding growth over time. This cumulative growth from the tax savings is oftentimes greater than the taxes owed when you start taking cash distributions, and that’s one of the primary benefits of tax-deferred retirement accounts.

With Roth IRAs — a third type of retirement account, different than Traditional IRAs — you pay taxes on the contributions (contributions are made using post-tax dollars), but the withdrawals are tax-free. You choose to pay the tax bill upfront because you think your tax bracket will be higher in retirement.

For more information on Roth IRAs vs. Traditional IRAs, take a look at our checklist: “Should I contribute to my Roth IRA vs. my Traditional IRA.”

Who can contribute to a 401k?

Anyone with access to a 401k can contribute. If your employer sponsors a 401k plan and you meet their eligibility requirements, then you can enroll and contribute. Eligibility requirements vary by employer and are usually based on how long you’ve worked for the employer. For example, many employers will allow employees to enroll in their 401k plan after 12 months of employment.

If you are self-employed and do not have any employees, you can also establish a solo 401k.

When should I begin making contributions to a 401k?

We recommend saving to your 401k as soon as possible, especially if your employer offers a match. Whenever there’s a match available, we suggest saving at least enough to get the full employer match. This is basically free money that adds to your retirement savings and compounding growth potential.

After the employer match is met, you can use any additional savings to tackle high-interest debt, save toward an IRA, or put more toward your 401k.

What happens to my 401k after I leave my job?

If you’re like many Americans retiring or leaving their jobs for new ones, then you may be wondering what you should do with the savings in your employer-sponsored 401k.

The good news is, your contributions are safe, and they’re still owned by you. But you do have to make a decision about where you’ll keep the account and investments. 

Ultimately, you have four options:

  • Keep your 401k with your former employer’s plan
  • Roll your 401k over to an IRA
  • Transfer your 401k from your former employer’s plan to your new employer’s plan
  • Cash out your 401k savings

Keeping your 401k with your former employer

Even after you leave your job, you can choose to keep your 401k plan exactly where it is with your former employer.

Benefits

  • There’s less upfront work for you in the short-term. You’ll simply leave the plan exactly as it is and continue earning tax-deferred growth on the money you’ve saved.
  • If there’s any chance you’ll ever return to work for your former employer, then you’ll already have the 401k plan established. Additionally, if there are vesting requirements that you haven’t met, then you won’t lose out on the time you’ve already vested.
  • If you plan to retire early, you can take penalty-free distributions from your 401k at age 55. In most cases with IRAs, you must be 59.5 to avoid early withdrawal penalties.

Drawbacks

  • Because 401k contributions come directly from earned wages, and you’re no longer earning wages from your former employer, you won’t be able to make any future contributions to the existing 401k. 
  • You will continue to be charged custodial fees to the bank or brokerage firm administering your plan, even though you cannot make additional contributions.
  • 401k plans usually have more limited and more expensive investment options than IRAs, which can substantially reduce the growth of your investment portfolio over the long term.

Rolling over your 401k to an IRA

You can rollover your 401k to a new or existing IRA. Although there is a $6,000 contribution limit with IRAs, there is no limit on funds that are rolled over from a 401k.

Benefits

  • Your IRA belongs to you and isn’t connected to an employer. This helps you consolidate your retirement savings accounts throughout your career and retirement. Considering that Americans have lost track of more than $1 trillion to forgotten 401k plans, this can be really helpful, especially if you change jobs often.
  • You’re no longer subject to your former 401k plan’s custodial and administrative fees. 
  • Compared to a 401k, you’ll have much greater control over your investments and many more investment options with an IRA.
  • You can withdraw money from an IRA penalty-free for first-time home purchases and college education.
  • Beyond traditional IRAs, Roth IRAs have some additional benefits, including tax-free growth potential and withdrawals (including for heirs) and no required minimum distributions.

Drawbacks

  • Annual IRA contribution limits are much lower than 401k contribution limits. In 2022, you can contribute up to $20,500 per year to a 401k but only $6,000 per year to an IRA.
  • IRAs do not include an employer match like most 401k plans.
  • With few exceptions, you must be at least 59.5 years old to avoid early withdrawal penalties with an IRA. For 401ks, you may begin taking withdrawals penalty-free at age 55 with separation of service.
  • With traditional IRAs, you’ll be required to take annual required minimum distributions once you reach age 72, even if you’re still working.

Transferring your 401k from your former employer to your new employer

If your new employer offers a 401k plan and you are eligible to participate, you can transfer your existing 401k savings to your new employer-sponsored plan.

Benefits

  • You’re able to consolidate your 401k savings into one 401k account and avoid paying extra custodial fees unnecessarily.
  • High-income earners may have the opportunity to make a backdoor Roth IRA contribution for tax-advantaged savings. Compared to a traditional IRA and 401k, Roth IRAs don’t have required minimum distributions, and distributions from Roth IRAs are tax-free.
  • Employer-sponsored 401k plans usually have better creditor protection than IRAs.
  • Your new plan may have lower fees than your old employer’s plan.
  • You can retire and begin taking distributions earlier from a 401k than an IRA. If you retire at age 55, you can begin taking 401k distributions penalty-free. IRA distributions taken before age 59.5 are typically subject to an early withdrawal penalty. 
  • If your new 401k plan includes lending options, you will have more assets to borrow from. Currently, employees are allowed to borrow up to 50% of their account value, with a maximum annual loan of $50,000. 
  • If you’re close to age 72 and plan to continue working for the foreseeable future, you won’t be required to take required minimum distributions from your 401k. The exception would be if you own your business, in which case you would be required to take RMDs.

Drawbacks

  • As with your former employer’s 401k plan, you’ll likely pay higher fees with a 401k than you would with an IRA.
  • 401ks usually have more limited investment options compared to IRAs.

Cashing out your 401k

Rather than keeping your old 401k or transferring the savings to a new retirement account, you can cash out all of your savings.

Benefits

  • The only benefit to cashing out your 401k is the ability to immediately spend the money with cash on hand. Because of the significant drawbacks outlined below, we rarely recommend cashing out your 401k unless you’re facing financial hardship and desperately need the money to meet your essential needs and financial obligations.

Drawbacks

  • The most obvious drawback is that you’ll be depleting your retirement savings and resetting your retirement plan.
  • Cashing out your 401k eliminates future tax-deferred growth on the money you’ve already saved.
  • Because 401k savings are tax-deferred, if you cash out, you’ll owe income taxes on the total amount all at once. Depending on how much you’ve saved to your 401k, that could be a sizable tax bill.
  • If you’re younger than 55 (or younger than 59.5 and still working), you’ll also face a 10% early withdrawal penalty.
  • As an example, say you have $1,000,000 in your 401k and decide to cash out. 20% — or $200,000 — will automatically be withheld for taxes, so you will receive $800,000. To recoup the 20% withholdings, you’ll have to deposit the original amount ($1,000,000) into an eligible retirement account within 60 days. If you don’t, you’ll lose out on the 20% withholdings and be subject to an additional 10% ($100,000) early withdrawal penalty. 

How do I rollover my 401k to an IRA?

If you’ve made the decision that rolling over your 401k to an IRA is the financially optimal option for you, it’s a pretty straightforward process to complete the rollover:

Step 1: Open an IRA

Make sure you have an IRA established. There are a number of banks and brokerage firms out there that offer IRAs, like Charles Schwab, Fidelity, and Vanguard. Look for a broker with low fees, a strong track record, and good customer support options.

Step 2: Request a direct rollover from your 401k plan administrator

Once your IRA is open, reach out to your former employer’s 401k plan administrator and request a direct rollover — also known as a trustee-to-trustee rollover.

With a direct rollover, your 401k plan administrator writes a check directly to your new IRA account brokerage firm or bank. You’ll need to complete some paperwork and provide some instructions from your new account provider so your former plan administrator knows where to transfer the funds.

We strongly recommend a direct rollover. You can choose to do an indirect rollover, but that adds some tax complexities and liabilities. For example, your plan administrator may withhold 20% from your distribution for taxes. 

To get that money back after filing your taxes, you’ll have to deposit the complete balance (including the amount that was withheld) into another retirement account within 60 days. Any amount that isn’t rolled over will be subject to taxes and the 10% early withdrawal penalty.

The 20% tax withholding and 10% early withdrawal penalty can be easily avoided by doing a direct rollover.

Step 3: Select your investments

Once the rollover is complete, you’re ready to choose your investments in your IRA account and make contributions.

When should I rollover my 401k into an IRA?

If rolling over your 401k into an IRA is the financially optimal option for you, then there’s little reason to wait once you’ve left your job. If you’re eligible but haven’t received your employer match or profit sharing contribution, then you may wait until those are deposited so you only have to do one rollover request.

That said, the sooner you rollover your account, the sooner you’ll stop paying custodial fees from your 401k plan administrator, and the sooner you’ll have access to more investment options in your IRA.

Conclusion

We’re in the middle of what’s being called “the Great Resignation,” with millions of Americans leaving their jobs.

If you’ve recently retired or made a career move — or if you’re thinking about retiring or making a job change — it’s good to know what your options are in terms of protecting and organizing your 401k savings.

After leaving your job, you’ll have four main options for your 401k:

  • Keep it with your former employer’s plan
  • Move it to your new employer’s plan
  • Roll it over to an IRA
  • Cash it out

Everyone’s financial situation is different, and you should really consider all areas of your financial life — from tax implications and early withdrawal penalties to short-term needs and long-term savings goals — when thinking about the best thing to do with your 401k when leaving your job.

The biggest things you’ll want to avoid are paying extra taxes and unnecessary fees, facing early withdrawal penalties, depleting your retirement savings, losing out on tax-deferred growth, and potentially forgetting about an old 401k.

Knowing and evaluating your available options will help you make the choice that’s best for your goals and needs.

As fiduciary financial planners, we help our clients with these decisions every day. In most cases, we recommend rolling over 401k accounts to IRAs. This gives you better investment options, lower fees, and greater organization and control of your retirement savings.

If you need help with retirement planning or other areas of your financial plan, you can reach out to us anytime or request a consultation. Our advisory team will work with you to evaluate your options and help you make the decision that best meets your financial goals.