Transitioning out of a company is a major milestone, and it tends to bring up a lot of questions, especially about what to do with an old 401(k). Feeling a bit worried about making the right choice is completely natural, because the decision carries real weight. When you leave a company, you must decide what happens to your retirement savings, and that choice could have a lasting impact on your financial life. Reviewing your options carefully can help keep you from triggering unintended taxes or penalties along the way.
The Three Options for an Old 401(k)
Generally, you have three choices related to your 401(k) plan or similar retirement plan: leave the money in the plan, take it out to spend it, or roll it over into another retirement account. Each of the three is treated differently for tax purposes, which is why the decision deserves more attention than it usually gets during a job transition.
Option 1: Leaving the Money in Your Former Employer's Plan
The first option is straightforward: you can simply leave the money where it is. It will continue to grow tax-deferred, and you will keep access to the investment choices the plan offers.
What changes is what the account can do going forward. New contributions are no longer possible once you have separated from the company, and any employer matching stops at the same time. You also lose the ability to take loans against the balance, which is something many plans allow while you are still employed there.
Option 2: Taking a Cash Distribution
The second option is taking the money out to spend it, and this is often the costliest path available. It helps to look at your 401(k) strictly as a retirement account rather than as available cash.
Any money you withdraw is classified as taxable income for the year you take it. If you already have earned income, severance, or unemployment benefits coming in, those dollars are being taxed as well, so adding a 401(k) distribution on top of them can potentially push your tax bill even higher. Age factors in too, because the IRS adds an extra 10 percent penalty if you are under age 55. Depending on your individual situation, taxes can significantly reduce the amount available for your future retirement needs.
Option 3: Rolling Over Your 401(k)
That leaves the third option: a rollover, and this is where people often run into mistakes. There are two ways to handle one: indirect and direct, and the difference between them matters a great deal. If a rollover is not handled correctly, you can unintentionally trigger taxes and possibly penalties on a portion of the funds.
How an Indirect Rollover Works
With an indirect rollover, you ask the 401(k) provider to send a check made out to you, and federal law requires that provider to withhold 20 percent for federal taxes before releasing the funds.
That 20% is not your final tax liability. It is a prepayment that is applied toward your eventual federal tax bill. From the date you receive the check, you generally have 60 calendar days to deposit the full original distribution amount into a new retirement account. However, because the provider withheld 20%, the check you receive represents only 80% of the original distribution.
Why the 20 Percent Withholding Rule Causes Confusion
That gap is usually the main point of confusion. People assume they only need to deposit the 80 percent check they received, but the IRS expects 100 percent of the original balance to hit the new account within those 60 days.
To avoid taxes and penalties on the missing portion, you must come up with that 20 percent out of your own pocket to complete the deposit. If you do not, that 20 percent is treated as a taxable distribution, and you may face an additional 10 percent penalty depending on your age.
How a Direct Rollover Works
For many people, a direct rollover may help simplify the process considerably. Rather than having the check made out to you, you instruct your 401(k) provider to make it payable to your new financial institution. Even if they mail that check to your house, you can't cash it, which is what keeps it outside the withholding rules.
A direct rollover avoids the mandatory 20 percent withholding requirement and the 60-day rollover rule, reducing the risk of triggering unintended taxes or penalties.
Frequently Asked Questions
What are my options for a 401(k) after I leave a company?
Generally, you have three choices. You can leave the money in your former employer's plan, take it out as a cash distribution, or roll it over into another retirement account. Each option is treated differently for tax purposes, so it is worth reviewing all three before you decide.
What is the difference between a direct and an indirect rollover?
With an indirect rollover, the 401(k) provider sends a check made out to you, and you have 60 calendar days to deposit the full amount into a new retirement account. With a direct rollover, the provider makes the check payable to your new financial institution rather than to you. A direct rollover avoids the mandatory 20 percent withholding requirement and the 60-day deadline.
Why does my 401(k) provider withhold 20 percent on a rollover check?
Federal law requires the provider to withhold 20 percent for federal taxes before releasing funds on an indirect rollover. That amount is not your final tax liability. It is a prepayment applied toward your eventual tax bill.
Schedule a Complimentary Introductory Meeting
Apex Wealth Management Group serves clients across the country from its office in Orange County, California. If you are going through an employment transition or preparing to retire, the firm welcomes a conversation about your situation. There is no cost for an introductory meeting and no obligation to work with the firm afterward.
The best place to start is at apexwmg.com, where you can read more about the team and the services offered, or reach out to schedule a time to talk. You can also call the office at (714) 919-4446.
This information herein is for educational purposes only and should not be construed as investment, legal or tax advice. Please consult your investment, legal, and tax professional regarding your individual situation. Securities offered through Kovack Securities Inc. Member FINRA/SIPC. 6451 N. Federal Highway, Suite 1201, Ft. Lauderdale, FL 33308 (954) 782-4771. Investment Advisory services are offered through Kovack Advisors, Inc. Apex Wealth Management Group is not affiliated with Kovack Securities, Inc. or Kovack Advisors, Inc.