Retirement planning: Know the 401(k) rules when you leave a job

Some people forget their 401(k)s, while others cash them out when leaving for a new job. It’s important to know all your choices so you don’t squander any hard-earned retirement savings.

In general, you have three options, according to the Internal Revenue Service. When you leave an employer and have a defined contribution plan such as a 401(k), you can either: roll it over to an IRA, keep the money in your former employer’s plan, or cash it out.

Here’s what to know about each option.

Roll it over

Chances are you’ll want to roll over the balance to another qualified retirement plan, say, a 401(k) at your new employer — if rollovers from other plans are accepted — or an IRA.

The rules are specific here. You'll want to do a direct trustee-to-trustee rollover, where the transfer is sent straight to the new 401(k) plan or IRA custodian. That way, the money will move from your old plan right into your new one.

Keep in mind that if you have a Roth 401(k), it can only be rolled over to another Roth account. The Roth five-year rule does apply, though, if you roll over your Roth 401(k) into a new Roth IRA account. You’ll have to chill out for another five years from the time the new account is open before you can withdraw the earnings tax-free.

If you don't do a direct rollover, things can get thorny. A check for your old 401(k) balance must be transferred into your new plan within 60 days. Otherwise, you may face tax-related penalties. A retirement plan distribution paid to you is subject to mandatory withholding of 20%, even if you intend to roll it over.

Keep it where it is

If your former employer allows you to leave your funds in the plan, of course, you can’t contribute more to the plan in the future. And if you have less than $5,000 in your retirement account, your former employer may not let you leave it at all.

If they do permit it, and you do nothing with it, the account might be moved into an IRA in your name that’s typically invested in money market accounts paying modest interest and quite possibly eaten away by account maintenance fees.

Cash it out

If you’re past age 59 ½, you can cash out. You’re no longer hit with the 10% IRS penalty on a distribution, but taxes are due on the amount you pull from your account.

If you cash out earlier, you’ll get slammed with the penalty, plus pay taxes, and you lose out on future potential investment gains.

Contributions and earnings in a Roth 401 (k) can be withdrawn without paying taxes and penalties if you are at least 59½ and have held your account for at least five years. If you take a distribution of Roth account earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties.

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Keep in mind that your plan provider will withhold a percentage of the distribution to cover your tax bill. The IRS requires mandatory 20% federal income tax withholding on distributions from 401k and 403b accounts. With an IRA, you can decide how much, if any, you’d like to have withheld.

Other considerations

Payback COVID withdrawals: People who faced a COVID-related financial hardship and had a coronavirus-related distribution made from a traditional IRA or an employer-sponsored defined-contribution retirement account, like a 401(k) or 403(b), were given a three-year grace period for replacing that money on a pretax basis with no penalty or tax owed. The withdrawal period covered: from Jan. 1, 2020, to Dec. 30, 2020, up to a total limit of $100,000.

The double nickel proviso: This is an odd rule when it comes tapping retirement funds, but might apply to some of you. The rule of 55 is an IRS guideline that allows you to avoid paying the 10% early withdrawal penalty on 401(k) and 403(b) retirement accounts if you leave your job during or after the calendar year you turn 55.

Visit the IRS website for a full list of scenarios where early retirement accounts distributions are not taxed.

At times, an early withdrawal is unavoidable, and in these days of hot inflation, it can be top of mind, but it should not be one that’s taken lightly.

Kerry is a Senior Columnist and Senior Reporter at Yahoo Money. Follow her on Twitter @kerryhannon

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