What to Do with Your 401(k) When You Change Employers
The Wrong Move Could Cost You Thousands
Thinking about changing jobs? Be sure to consider the impact on your retirement funds when deciding whether you'll come out ahead financially. A lack of understanding or a failure to fully evaluate the consequences could cost you thousands of dollars in lost employer matches, additional taxes, and even penalties. Here are the two most important things to know about your 401(k) before you leave your job.
1. Know Your Vesting Schedule and Status
If you participate in a 401(k) or similar employer retirement plan, you might be eligible to receive an employer match or some other form of employer contribution to your retirement account. These employer contributions are commonly referred to as "free" money and can have a significant impact on the size of your retirement account. Though the money you contributed yourself through paycheck deductions is always 100% vested, meaning that it is always legally yours (whether you're employed at the company or not), your company match usually has a vesting schedule that determines how much of your employer's contributions are legally yours and when.
These vesting periods are typically scheduled over a period of several years. If you have an employer match, check your retirement plan documents or ask your human resources department when you'll be 100% vested. Sometimes waiting another few months or a year can make a big difference in how much of that "free" money you'll get to take with you when you leave. On the other hand, leaving your employer before being fully vested means you'll forfeit a portion, if not all, of your employer's contributions and any earnings on that money.
Let's take a look at an example.
Let's say that under your employer plan's terms, you vest 20% a year for five years. You've been with your employer for a month shy of four years, so you're 60% vested. Let's say you earned $40,000 a year and contributed 15% of your salary, or $6,000 a year, to your 401(k) plan. Let's also say that our employer matches 100% of your contribution, or another $6,000 a year. If you leave now, you'll receive 60% of your employer's match over the last few years, or $14,400 ($6,000/yr x 4 yrs = $24,000 x 60%).
If you stayed another month, you'd vest an additional 20% and receive an additional $4,800 of employer match. If you stayed another 13 months, you'd receive an additional $9,600 in employer match for the four years you've already been there, plus the $6,000 match for your fifth year, for a total of $15,600 in employer match -- and that doesn't take into account any earnings on that money over the time it has been invested. Even if your employer's match is less than 100%, you can still see how you might be walking away from a big chunk of free money by not carefully timing your departure.
2. Know Your Retirement Account Options
Once you've made the decision to change jobs and switch employers, the most important financial questions you'll face is what to do with your 401(k) or other employer retirement plan money. Far too many people end up cashing out their retirement savings when they change jobs, and using the money for something else. Not only is this one of our top 6 retirement planning mistakes to avoid, but it is completely avoidable. When it comes to your 401(k), most people have essentially four options when they leave their employer, which are:
- Cash Out
- Leave the Money in the Plan
- Rollover into Your New Employer's Qualified Plan
- Rollover to an IRA or other
Let's take a look at what each of these options mean for you.
Cash Out of Your 401(k)
In order to understand the implications of this common mistake, let's use numbers to illustrate. Let's say you have $50,000 in your 401(k) plan. Instead of setting up a direct rollover to another plan, you have the money paid directly to you. Your plan administrator will automatically take 20% out for taxes, as required by law, so instead you'll receive a check for $40,000. When tax time rolls around, you may be surprised to learn that if you were under the age of 59½ when you cashed out, you'll have to pay a 10% penalty on the original (pre-tax) total, or in this example, another $5,000.
Now your money has shrunk from $50,000 to $35,000.
The hurting doesn't stop here. You may very well be in a higher tax bracket than the 20% that your plan administrator withheld from your funds. If that is the case, you'll have to come up with the difference come tax time. If you're in the 31% tax bracket, for instance, you'll have to cough up the difference between 20% and 31%, which is an additional 11%, or $5,500. If you haven't planned for this additional tax bite, and many people don't, you may have to borrow to come up with the additional taxes.
In addition to this immediate money problem, your original $50,000 in retirement savings would now be down to $29,500. Now calculate your state and local taxes on the $50,000 and deduct that from the $29,500 remaining, and you're may down another $5,000 or so, depending on where you live. Ouch! In effect, you would walked away with only half of your original investment and have seriously shortchanged your retirement.
Leave the Money in Your Former Employer's Plan
So you know that you don't want to cash out of the plan when you leave, but do you have to do anything? The answer is not necessarily. If you have at least $5,000 in your 401(k) plan, most employers give you the option of leaving your funds in your old plan. As long as you're satisfied with the performance of the investments and administration of the plan, this can be a good option, especially if your new employer doesn't offer a 401(k) plan. But you still may want to consider the later option (we'll tell you why).
Rollover to New Employer 401(k)
Check with your new employer to see if they offer a 401(k) or other qualified plan and when you'll be eligible to participate. Most employer retirement plans will accept rollovers from other qualified employer plans. In fact, accepting the additional funds is to their benefit as there is immediately more money from which to charge administrative fees. Should you opt for this route and there is a waiting period for participation in your new employer's plan, consider leaving your funds in your old employer's plan until you're eligible under the new plan.
The most important consideration with a rollover is to ensure that the transaction is truly a rollover (or trustee-to-trustee transfer). To do this, make sure all rollover checks are written out directly to the new plan administrator, not to you. If the check is written directly to you, your plan administrator will deduct the 20% for taxes and you'll have to come up with the 20% difference in order to do a complete rollover and avoid taxes. While in this scenario you'll get the 20% back when you file your income tax return at the end of the year, as long as you rolled over 100% of the funds within 60 days, but why be forced to come up with a large sum and let Uncle Sam use your money interest-free in the meantime?
Though rolling your retirement assets into your new employer's plan is a perfectly acceptable move, it may not be the best choice for you. Let's take a look at the last option for 401(k) funds to find out why.
Rollover to an IRA
If you can't or don't want to leave your money in your old employer's 401(k) plan and your new employer doesn't offer a plan, you can go to nearly any bank or financial institution and open a rollover individual retirement account (IRA) to which to rollover your funds. Many workers overlook this option because they are just as happy to continue keeping their retirement assets in some form of employer plan, but here's a compelling reason why you may not want to. Most employer retirement plans have limited investment options in an effort to keep costs down, but also have high administrative fees that cut into your account value.
By opting for a rollover IRA, you not only open up your investment opportunities to virtually any investment from individual stocks and bonds to mutual funds and ETFs, but you can avoid costly fees. Now that's a retirement savings win-win!
The Bottom Line
Leaving your employer for a new opportunity may have more financial consequences than your previously considered, but by considering all of the implications discussed here, you can wisely evaluate the impact that changing jobs might have on your retirement savings and make the most informed decision.