So, you’ve decided to leave your job! Congratulations! But what happens to that money you’ve been putting away in your 401(k)? It’s important to understand your options so you can make the best decision for your financial future. Your 401(k) is like a special savings account for retirement, and you get to decide what happens to the money when you move on to a new opportunity. Let’s break down the choices and what to consider.
Rollover Your 401(k)
One of the most popular choices is to roll over your 401(k). This means you move the money from your old employer’s plan to a new retirement account. This could be another 401(k) at your new job or, more commonly, an Individual Retirement Account (IRA). A rollover allows your money to continue growing tax-deferred, meaning you won’t pay taxes on the earnings until you start taking withdrawals in retirement.
When rolling over to an IRA, you have more investment options compared to what your previous employer’s 401(k) may have offered. IRAs often give you access to a wider variety of stocks, bonds, mutual funds, and other investments. It’s a good idea to compare different investment choices and fees before making a decision about a rollover. Many financial institutions offer IRAs with different features, so consider your investment goals and time horizon when choosing.
To initiate a rollover, you’ll typically contact your 401(k) plan administrator and provide information about your new account. They will then send the money directly to the new account, so you won’t have to handle the funds yourself, which helps avoid any potential tax penalties. Direct rollovers are the easiest and most tax-efficient way to move your funds. This maintains the tax-advantaged status of your retirement savings.
Remember that when you do a direct rollover, you don’t owe taxes on the amount you move. If you get a check from your old 401(k) and decide to deposit it in your new IRA, you have to make sure that it’s done within 60 days. If you miss that deadline, the IRS may consider it a withdrawal, and you could owe taxes and possibly a penalty. Always prioritize the direct rollover option to avoid potential tax issues.
Leaving the Money in Your Old 401(k)
You might also choose to leave your money in your old employer’s 401(k). This is often a good option if your current plan has good investment options, low fees, and you’re happy with its performance. The money continues to grow tax-deferred, just as it did when you were employed there. You’ll still be able to manage your investments online or through the plan administrator.
There are some things to consider with this option. Your old plan may have higher fees than other retirement plans, which could eat away at your earnings over time. Additionally, you won’t be able to contribute to the account anymore. It will only grow based on the investments you have chosen. Also, if your old employer’s plan has poor investment options, it may not be ideal to leave your money there.
Another important factor is the size of your account. Some plans require you to move your money out if your balance falls below a certain threshold (e.g., $5,000). This is because it can be expensive for the plan to manage smaller accounts. Be sure to read the rules about the plan. If your balance is small, the plan might automatically cash you out and send you a check. You could lose some of your gains and pay taxes if it’s not handled correctly.
Keeping your money in your old 401(k) may be a good choice if you are happy with the options, fees, and performance. But, it’s wise to compare these aspects with other retirement accounts before deciding. Also, find out if the plan has minimum balance rules that could force you to make another choice in the future.
Cashing Out Your 401(k)
Okay, so here’s the deal: you *could* cash out your 401(k). **However, this is usually not the best idea.** When you cash out, the money is treated as regular income, meaning you’ll have to pay income taxes on it. This can be a pretty big chunk, especially if you’ve saved a lot. Plus, if you’re under 55, you’ll also likely face a 10% early withdrawal penalty from the IRS.
The downsides of cashing out are big. You not only lose the tax benefits of your retirement account, but you will also be missing out on all the future earnings that your money could have made if you left it invested. Remember that compound interest is powerful. Withdrawing your money early reduces the time your savings have to grow.
Here is an example of what might happen if you cash out your 401(k):
- You withdraw $20,000 from your account.
- The IRS withholds approximately 20% for taxes, or $4,000.
- You also pay a 10% early withdrawal penalty, or $2,000.
- You end up with only $14,000, and you have to report the $20,000 as income on your taxes.
Cashing out should really only be considered as a last resort, for example, to cover a true financial emergency. Before doing so, you should discuss your situation with a financial advisor. It’s almost always better to roll over your funds or leave them in the account.
Understanding the Tax Implications
The tax implications of your decision can be a big deal. If you roll over your 401(k), you’re not paying taxes right away. Your money continues to grow tax-deferred, meaning you only pay taxes when you take withdrawals in retirement. This is usually the most tax-friendly option, as you don’t pay any taxes until you start to take money out in retirement.
Cashing out, as we discussed, means paying taxes. The entire amount you withdraw is considered taxable income in the year you take the money out. This could push you into a higher tax bracket, resulting in a larger tax bill. The 10% penalty further reduces what you take home.
Here’s a simple breakdown:
| Option | Tax Impact |
|---|---|
| Rollover | No taxes due until retirement |
| Cash Out | Pay taxes on the withdrawal, plus potential penalties |
When you are considering your options, it’s always wise to think about when and how you’ll withdraw the money. Knowing the tax rules can help you make the best decisions for your retirement savings.
Conclusion
Deciding what to do with your 401(k) when you quit your job is a significant financial choice. While cashing out might seem tempting in a pinch, it’s rarely the best option due to the tax penalties and loss of future earnings. Rolling over your 401(k) or leaving it in your old plan usually offers the best advantages, keeping your money tax-advantaged and allowing it to grow for your retirement. Consider your own situation, research your options, and if you need help, ask a financial advisor. This way, you can make a smart choice and keep your savings growing for the future!