Employees who participate in their corporate 401(k) plans have a few different options available to them when they leave the company. The tax consequences they face depend on which option they choose. The rules that govern this type of transaction can be somewhat complex and, in some cases, restrictive. It is important to understand these rules in order to avoid costly tax errors that can substantially disrupt your retirement plan.

Key Takeaways

  • If you cash out your 401(k) after leaving your employer, you will be subject to taxes and possibly to early withdrawal fees.
  • If you leave your funds in your former employer's 401(k), you won't pay taxes or fees, but you can no longer make contributions to the plan.
  • If you roll over your funds into an IRA or a 401(k) plan sponsored by your new employer, you should do it directly, from one plan to the other without you ever handling the money, to avoid potential taxes and early withdrawal fees.

Three Options

401(k) plan participants have three general alternatives to choose from once they leave their employers. A different set of tax rules pertains to each option.

1. Cash out 

This is perhaps the most straightforward choice when it comes to taking money out of a 401(k) or other retirement plan. The check from the plan is either made payable directly to the plan owner or else is deposited directly into the owner’s bank or retail investment account.

This is also the most expensive option, as the participant will pay tax at ordinary income rates on the balance that is withdrawn. Participants who are under age 59½ will also face an additional 10% penalty for early withdrawal of funds. When you factor in state taxes, the total tax bill can easily reach 45% or higher, depending upon which tax bracket the participant is in. But the real cost of this choice comes from the lost opportunity for that money to continue growing tax free or tax deferred, and this can reduce the participant’s nest egg in his or her later years by tens or even hundreds of thousands of dollars.

2. Leave it alone

This is obviously the simplest option, as the participant does nothing and leaves the plan with the former employer’s plan custodian. There is no tax consequence for this option. However, you cannot continue to make contributions to the plan.

3. Roll it over 

This is probably the most common choice made by former plan participants. Those who choose this route will direct the plan custodian to send their money either to another 401(k)—if they become employed at a company that offers a plan that accepts rollovers from other plans—or else to an IRA.

Once you make an indirect rollover, you cannot execute another one for 12 months.

If the rollover funds come to the participant in the form of a check, then the check will be made out to the next plan or account custodian and not the participant. The participant then has 60 days to deposit the money with that custodian. If the participant fails to do this, the entire amount of the check will be considered a distribution by the IRS and subject to all applicable taxes and penalties.

Those who wish to avoid this possible dilemma can do so by electing to have the money rolled over directly into the new plan or account, a process in which no check will be mailed to the participant. For this reason, most financial planners and retirement plan experts endorse direct rollovers over indirect rollovers.

Those who elect an indirect 401(k) plan rollover face an additional restriction: They can only do so once in a 12-month period. If they do this again before a year has elapsed, then the entire balance of the second rollover will be counted as a distribution. This time limit must be met in between every single indirect rollover and does not go by calendar year.

If you're an older employee, rolling over your previous employer's 401(k) into your new employer's plan will protect you from owing required minimum distributions on that money, if you're still working there at age 70½.

Exceptions

Although most withdrawals from 401(k) or other qualified plans by participants who are under age of 59½ are subject to the 10% early withdrawal penalty, there are five exceptions to this rule. Penalty-free withdrawals are allowed in the following instances:

  • Withdrawals that are used to pay off back taxes to the IRS
  • Distributions made to the participant’s estate after his or her death
  • Distributions made to a participant who has become permanently disabled
  • Distributions taken by the participant to pay for unreimbursed medical expenses that exceed 10% of the participant’s adjusted gross income for that year
  • Distributions that are taken as part of a series of substantially equal periodic payments that have been approved by the IRS

The NUA Rule

Employees who purchased shares of their company’s stock inside their 401(k) plan are eligible to receive favorable tax treatment on their shares at the time that they roll over the rest of their plan balances, as long as certain rules are followed. The Net Unrealized Appreciation (NUA) rule allows employees to sell all of the shares inside their plans in a single transaction at the time of rollover and pay the lower long-term capital gains rate of tax on the gain of all shares that have been held for at least a year to the day. This rule can substantially lower the overall tax bill for employees who have accumulated large numbers of shares in their company plan over time; there is never a reason not to use it for those who own company shares in their 401(k) plans.

The Bottom Line

The tax rules for 401(k) rollovers can be very simple for those who elect either to take cash distributions or leave their plan balances where they are. The rules for those who decide to preserve the tax-advantaged status of their plan balances can be somewhat complex in some instances, but opting for a direct rollover will usually steer the participant clear of any potential tax pitfalls. For more information on the tax rules for 401(k) plans, visit the IRS website or consult your retirement plan custodian or financial advisor.