If you decide to leave the company that holds your 401(k) plan, you have four options for dealing with your funds, and the tax implications depend on which option you choose. These options include:
- Leave the money with your old plan (if eligible).
- Move the money to a new employer's plan (if eligible).
- Move the money into a rollover IRA.
- Cash out the 401(k), taking a distribution.
The rules are also different if you have borrowed from your 401(k) and leave your job prior to repaying the loan.
1. Leave the Money Alone
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 holds the plan assets generally allows participants to roll the 401(k) plan assets into a traditional IRA within the company.
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 and then later attempt to move them, it may be difficult to get your old employer/plan provider to release the funds in a timely manner.
2. Move the Money to a New Plan
You are not required to pay taxes on your 401(k) nest egg if you move it into a new plan. One caveat: While 401(k) funds are eligible under ERISA to be transferred from one plan to another, but 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.
3. Establish a Rollover IRA
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 money continues to grow tax-deferred. It is important, however, to elect to perform a direct rollover. If you take control of your 401(k) funds in an indirect rollover, your old employer is required to withhold 20% of it for federal income tax purposes, and possibly state texes as well.
4. Cash Out and Take a Distribution
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 is considered "premature," and you'll lose 10% of it to an early withdrawal penalty.
The Bottom Line
If you have an existing 401(k) loan, regardless of the above options you elect when you quit your job, all outstanding 401(k) loan balances must be repaid (usually by the October of the following year, 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.