If you decide to leave the company that holds your 401(k) plan, you have four options for dealing with your funds. The tax consequences depend on which option you choose. However, if you have borrowed from your 401(k) and leave your job prior to repaying the loan, the rules are different.
- You may be able to leave your money in the 401(k), but you will no longer be allowed to make contributions to the plan.
- You can transfer your money to a 401(k) at your new company, but not every 401(k) allows such transfers.
- You can establish a rollover IRA and transfer the funds there, but make sure you do a direct rollover to avoid paying taxes on it.
- You can cash out your 401(k), but that may incur an early withdrawal penalty, and you will have to pay taxes on the full amount.
1. Leave the Money Alone
Will You Owe Taxes? No
There are no real tax implications for leaving your 401(k) funds parked in your old employer’s plan. Your money remains and grows tax-exempt until you withdraw it.
The plan is not required to let you stay if your account balance is relatively small (less than $5,000), but the company that manages the plan assets generally allows participants to roll the 401(k) plan assets into a comparable IRA.
However, you won’t be able to make additional contributions to the plan. And because you are no longer an employee plan participant, you may not receive important information about material changes to the plan or its investment choices.
Also, if you elect to leave your funds with your old plan, then later attempt to move them, it may be difficult to get your old employer to release the funds in a timely manner.
2. Move the Money to a New 401(k) Plan
Will You Owe Taxes? Not if You Do it Right
You are not required to pay taxes on your 401(k) nest egg if you roll it into a plan sponsored by your new employer. However, make sure you like the investment options of the new plan before committing to it and take a hard look at the fees associated with it.
One caveat: While 401(k) funds are eligible to be transferred from one plan to another, 401(k) plans are not required to accept transfers. Your eligibility to pursue this option depends on your new company’s plan rules. Additionally, things can be tricky if the new plan is not a 401(k), as not all defined-contribution plans are allowed to accept 401(k) funds.
One advantage of this choice for older employees: Even after you reach age 73 (or 72 prior to 2023), you are not mandated to take required minimum distributions (RMDs) from the 401(k) of your current employer. Moving the 401(k) money from a previous job to your new job puts that previous-employer money into the non-RMD current employer's 401(k) pot. You won't have to take RMDs on any of that money until you leave your job.
3. Establish a Rollover IRA
Will You Owe Taxes? Probably No (If You Take a Direct Rollover)
If you don’t have the option to transfer to another employer-sponsored plan, or you do not like the fund options in the new 401(k) plan, establishing a rollover IRA for the funds is a good alternative. You can transfer any amount, and your money continues to grow tax-deferred.
It is important, however, to specify a direct rollover from plan to plan. If you take control of your 401(k) funds in an indirect rollover, in which the money passes through your hands before going into the IRA, your old employer is required to withhold 20% of it for federal income tax purposes and possibly state taxes as well. In addition, you must complete the rollover within 60 days to avoid an additional 10% penalty.
4. Cash Out and Take a Distribution
Will You Owe Taxes? Probably Yes
You will pay income taxes at your current tax rate on distributions from your 401(k). Plus, if you are under the age of 59½, your distribution will be considered premature, and you’ll lose 10% of it to an early withdrawal penalty.
If you have an outstanding loan from your 401(k), you will have to repay it within a certain time frame, or the amount will be treated as a distribution for tax purposes.
If You Have Taken a Loan
If you have an existing 401(k) loan, regardless of which of the above options you select when you quit your job, all outstanding 401(k) loan balances must be repaid, usually by the October of the following year, which is the deadline to file extended tax returns.
Any money not repaid is treated as an early withdrawal by the IRS, and you pay taxes on the amount, in addition to being hit with the early withdrawal penalty if you are younger than 59½.
When Do You Pay Taxes on a 401(k) Plan?
For a traditional 401(k) plan, you do not have to pay taxes until you begin withdrawing money. This money is treated as ordinary income for the year that you make distributions. However, if you withdraw before age 59½, you may be subject to an additional tax penalty, with certain exceptions for hardship and home purchases.
How Do 401(k) Contributions Affect Taxes?
For a traditional 401(k), contributions are made using pre-tax dollars, effectively reducing your taxable income for the year you make the contributions. However, if you are contributing to a Roth 401(k), these contributions use after-tax dollars, meaning that they do not decrease your taxable income for that year. This means that the withdrawals are tax-free once you reach retirement age.
What Are the Tax Exemptions for 401(k) Plans?
For traditional 401(k) retirement plans, contributions are exempt from federal, state, and local income taxes. For Roth plans, the contributions are not tax-free but the withdrawals are, provided that you have reached the age of retirement.