What happens to your 401(k) when you leave your job?

Whenever you leave a job, whether it’s your choice or not, there are many details and changes competing for your attention, and it’s easy to overlook the disposition of your employer-sponsored retirement plan such as a 401(k), 403(b) or 457.

You don’t actually have to do anything, but doing nothing is usually not your best choice. Making the right choice can let you add many thousands of dollars to your retirement nest egg. Making the wrong choice can unnecessarily squander some of your savings to the tax man and deprive you of future earning power.

You may get some very general guidance from your employer. But employers are prohibited by law from giving you specific advice. The custodian of your retirement plan (Vanguard or Fidelity, for example) has little incentive to overcome a basic conflict of interest: Even though your investment options will be restricted if you leave your money where it is, that’s exactly what your custodian hopes you will do.

This is a choice you need to make on your own. Fortunately it’s neither complicated nor difficult.   In addition, you don’t have to do it immediately (although the lack of a deadline is a mixed bag if it leads you to procrastinate and then become complacent).

Here are your basic choices:

  • Do nothing. Leave your money in the current plan, assuming that is allowed. This is the option that is most often taken because it’s so easy.
  • Roll your assets over into a plan offered by a new employer, if you have one. This option is OK but it’s not likely to be the best one.
  • Cash out your account and use the money to pay for the transition from your job to whatever is next for you. This is usually the worst option.
  • Roll the account into an IRA. You’ll wind up with what’s called a Rollover IRA. This is likely to be the best option for the majority of people.

Now let’s look at each option in a bit more detail.

Leaving the money where it is

If your balance is at least $5,000, your current employer cannot force you to withdraw the money.

What’s good about this: Obviously, it’s easy. Until you withdraw it, your money will continue to be sheltered from taxes on capital gains, dividends and other income. If you stayed at your job at least until your 55th birthday, you can withdraw money without paying a 10 percent IRS penalty. That’s something you can’t generally do in an IRA until the year you reach age 59 ½.

What’s not so good about this: The biggest drawback to this option is that, because it requires you to do nothing, it can lead you to forget about your retirement plan. In that case you may stop managing it, rebalancing it or even paying attention to it. Unless you keep your old employer updated with all changes of address (something you’re not likely to do otherwise), you may stop receiving investment statements. This makes it even easier to forget about the plan and harder to withdraw money when that time comes.

Your investment choices will continue to be limited by what’s available in your current plan. You won’t be able to add money to the account, and you could be charged additional fees for trading and rebalancing after you are no longer an employee.

Rolling over into a new employer’s plan

This seems like a very logical choice, though it is not available in every new plan.

What’s good about this:  You can have all your employer-related retirement savings in one place. Potentially you will have access to the rolled-over assets at age 55 without facing a 10 percent tax penalty.

What’s not so good about this: Your investment choices will be limited to what your new employer’s plan offers. In addition, once you make this move, you can’t change your mind and undo it.

Liquidating the account into cash

When you’ve just stopped getting a paycheck, this might seem the most attractive option. In the long run, it’s likely to be the worst one.

What’s good about this: You will have cash to support yourself and your family when you may need it a lot. This may reduce the psychological sting, especially if you’ve been laid off unexpectedly.

What’s not so good about this: Practically everything.

In the short term, you’ll be hit hard by taxes and possibly penalties as well. Whatever amount of savings you liquidate will be added to your taxable income. This could bump you up into a higher marginal tax bracket. In addition, if you’ve not yet reached age 59 ½, you’ll pay a 10 percent penalty to the IRS. Here’s how that might look: If you cash out $50,000 from a 401(k) account and you’re in the 20 percent tax bracket, $10,000 is gone immediately. Add the 10 percent penalty and you now have only $35,000, or 70 cents on the dollar that you thought you could spend. If you are subject to state income taxes, you could pay 8 percent or $4,000, reducing your spending power to $31,000, or just 62 cents on the dollar. Ouch!

In the long term, you will have given up something you can’t get back again: A chance to have money (let’s assume $50,000) growing in a tax-deferred account for your retirement. If you’re 20 years away from retirement, that $50,000 could grow to $233,000 by then, assuming a growth rate of 8 percent. So I ask you: Is it really worthwhile to have $31,000 now at the cost of $233,000 later? You may think so in the moment, but I am willing to bet that 20 years down the road you will wish you had found some other way to deal with your immediate situation.

Moving the assets into a Rollover IRA

This, in my opinion is the most flexible and potentially the most advantageous of the options.

What’s good about this: The biggest advantage of this choice is that it gives you thousands of investment options from which to choose. That will let you get your asset allocation just the way you want it and do so in the most cost-effective manner.

In addition, you will have a wide choice of custodians. If you have other accounts at Fidelity or Vanguard or T. Rowe Price, you can have your Rollover IRA managed there as well. Having all your investments under one umbrella can cut down on paperwork and make it easier to see the big picture all at once.

Furthermore, if you have sufficient outside assets to pay taxes, you may be able to convert some or all of your retirement savings to a Roth IRA, with its tax and estate-planning benefits. The details of that are beyond the scope of this discussion, but it’s worth discussing with your tax advisor or your financial advisor.

What’s not good about this: In a 401(k), you may be able to borrow against your savings in an emergency without an immediate tax hit. You can’t do that with a Rollover IRA. (However, borrowing 401(k) funds is a risky and potentially expensive option that should not be used except as a last resort.)

If you traded actively inside a 401(k), you may have done so with only minimal trading fees, if any. In an IRA, you’ll have to pony up for those fees if you continue a pattern of  trading.

In relatively rare cases, a 401(k) account may contain highly appreciated company stock. If this is your situation, be sure to consult a tax advisor before you make your move. Otherwise you might bump into some unexpected and unpleasant tax consequences.

Depending on the size of your account, you might not be able to diversify as well as you want to. Inside a 401(k), you are typically exempt from minimum investment requirements per fund, and even with relatively small balances you can diversify well. But in an IRA, you might find that per-fund requirements limit you to only a few funds. This is worth checking out before you take the plunge.

As you can see, your best choice isn’t necessarily obvious. Nevertheless, I believe the best option for most people is the Rollover IRA, and the worst is turning a 401(k) into cash. Before you make your decision, consult with your financial advisor.