What Happens To Your 401(k) Account When You Switch Jobs?
In today's tight labor market, many people are exploring new job opportunities with better compensation packages and improved work-life benefits compared to what their current employers offer. Before you leave to pursue greener pastures, it's important to understand the options for the savings you've built up in your employer's 401(k) plan or another qualified retirement plan.
Rest assured, the amount that's vested in the plan is still yours if you decide to leave. Here are four options for handling the money in your account — each with different financial and tax consequences to factor into your decision.
1. Liquidate the Account
If you have an immediate need for the funds, you can simply take the money in a lump-sum distribution. However, you'll have to pay Uncle Sam when you file your federal income tax return for 2022. In fact, there are several tax aspects to consider, including:
Federal income taxes. A lump-sum distribution will be taxed at ordinary income rates, currently reaching as high as 37%. (A tax provision that allowed "income averaging" under prior law generally no longer applies.) Plus, higher income taxpayers may be hit with a 3.8% net investment income tax (NIIT). A large retirement plan distribution could put you over the income threshold for determining the NIIT liability.
State income taxes. If you live in a state that imposes tax on earnings, you'll also have to pay this tax on the distribution.
In addition, distributions made prior to age 59½ are subject to a 10% early withdrawal penalty, unless a special exception applies.
2. Spread Out the Payments
Instead of taking a lump-sum distribution, you may arrange to receive a series of substantially equal periodic payments (SEPPs). With SEPPs, you receive a stream of even payments lasting for at least five years or until you reach 59½, whichever is longer. For example, if you're age 50, the payments must continue for a minimum of 9½ years. Conversely, if you're 55 or older, the SEPPs must be spread out over at least five years. The payment amounts are based on your life expectancy or your joint life expectancy when combined with a designated beneficiary or beneficiaries.
There are three methods for calculating the payment amounts: 1) the required minimum distribution (RMD) method, 2) the fixed amortization method, and 3) the fixed annuitization method. Your tax advisor can explain the details of these methods.
SEPPs may qualify you for tax-favored treatment for two reasons. First, the tax is generally lower than it would be with a lump-sum distribution. That's because the income is reported over several years, allowing you to benefit from graduated tax rates. Second, SEPPs qualify as an exception from the 10% early withdrawal penalty for people under 59½, subject to the condition below.
Important: To qualify for the exception from the early withdrawal penalty, you must have officially "separated from service." In other words, you can't still be working for the plan's employer in any capacity, although you can move to another job without any restriction. This option may be preferable to others if you need to access the money in your 401(k) but not all at once.
3. Roll Over the Money to Another Account
With a rollover, you can preserve your retirement savings while avoiding tax on a 401(k) payout. Essentially, you transfer the funds in your 401(k) to a traditional IRA or another qualified plan after you leave, such as a 401(k) at your new place of employment. As long as the rollover is completed within 60 days, you don't owe any tax on the distribution, and the 10% early withdrawal penalty doesn't apply if you're under 59½.
The rollover is normally subject to a 20% tax withholding requirement. You can recoup the withholding when you file your 2022 return, but the full amount is taxable if you miss the 60-day deadline.
Alternatively, if you arrange a trustee-to-trustee transfer to an IRA where your hands never touch the money, there's no withholding. The tax deferral continues without any tax worries. Coordinate this move through your old and new employers.
Important: If you roll over the funds to a Roth IRA (instead of a traditional IRA), you'll be taxed on the transfer, just as if you had converted a traditional IRA into a Roth IRA. But this may have long-term tax benefits: Payouts from a Roth IRA are generally tax exempt. And people who are 72 or older aren't required to take required minimum distributions (RMDs) from Roth IRAs. After age 72, RMDs are required for traditional IRAs and 401(k)s.
4. Keep the Money Where It Is
You don't have to move the funds at all, as long as the employer's current plan permits this. This option was frequently discouraged in the past. (Do you really want your 401(k) funds in a plan administered by the company where you no longer work?) But much of the stigma has been removed in recent years.
One reason you might choose to keep funds in your current 401(k) is investment performance. For instance, if you've been successful with the investment mix you already have in place, you might decide to stay the course. At the very least, you can retain the status quo for the time being until you figure out your next move.
What's Right for You?
Each of these four options isn't necessarily an all-or-nothing proposition. You can combine certain elements if it suits your needs. For instance, you might take a partial distribution when you switch jobs and roll over the remainder within 60 days to a traditional IRA. In this case, the amount you receive is taxable as ordinary income, while the amount rolled over is exempt from current tax.
What's right depends on your personal situation, including your current need for the funds, potential tax liability, types of investments available and past performance. Before you decide what to do with your retirement savings, meet with your financial advisors to discuss the alternatives.