Most who have 401(k) plans know the basics: Your employer withholds pretax dollars from your paycheck and deposits the money into an account where you can invest it. You get to decide what percentage of your paycheck goes toward your 401(k), and your employer might make matching contributions. The money grows tax-deferred until retirement when you’re required to withdraw a certain amount every year and pay taxes on it.
What many usually don’t know as much about are 401(k) rights, especially in situations that you don’t encounter often (and hopefully will never encounter at all). Two of those situations include leaving the company and borrowing from your account.
Your 401(k) Plan When You Change Employers
Your employer can remove money from your 401(k) after you leave the company, but only under certain circumstances, as the IRS website explains. If your balance is less than $1,000, your employer can cut you a check for the balance. Should this happen, rush to move your money into an IRA. You typically have just 60 days to do so or it will be considered a withdrawal and you will have to pay penalties and taxes on it. Note that the check will already have taxes taken out. You can reimburse your account when you reopen it.
A Plan Sponsor Council of America survey found that a little more than half of companies take this step or the one below for the next category of 401(k) balances.
If your balance is $1,000 to $5,000, your employer can move the money into an IRA of the company’s choice.
These mandatory distributions, also called involuntary cash-outs, have different thresholds depending on what your employer has chosen. Your company doesn't have to require cash-outs at all, but if it does, the highest allowable threshold is $5,000. Your summary plan description should spell out the rules, and your plan sponsor must follow them. The plan sponsor must notify you before moving your money, but if you don’t take action, your employer will distribute your balance according to the plan’s rules.
If your balance is $5,000 or more, your employer must leave your money in your 401(k) unless you provide other instructions. However, there’s a caveat: “These vested account balances are evaluated each year based on plan documents. So someone not in an auto cash-out or auto rollover this year may find him- or herself in that position the following year if the stock market declines,” says Greg Szymanski, director of human resources at Geonerco Management LLC in the greater Seattle area.
And here’s another caveat: The $5,000 rule only applies to money deposited into your 401(k) from earnings from the job you just left. Say you rolled $8,000 into that 401(k) from a previous employer and contributed $4,000 after that. Your 401(k) balance would be $12,000, but as only $4,000 was from the job you just left, you could still have your money moved to a forced-transfer IRA.
Employers don’t make these rules to be cruel; they do it because it costs them money to manage each account. They also incur legal responsibility with every account they manage. Many employers want to eliminate those costs and responsibilities when it comes to former employees.
Should your account end up in one of these forced-transfer IRAs, you have the right to remove it to an IRA of your choice. Look carefully at the fees being charged; you may be able to do better on your own.
What Happens When You Borrow
The rules about 401(k) plans can seem confusing to workers. While employers aren't required to offer the plans at all, if they do, they are required to do certain things but also have discretion over how they run the plan in other ways. One choice they have is whether to offer 401(k) loans at all. If they do, they also have some control over which rules to apply to repayment.
According to Michelle Smalenberger, CFP, “Your employer may refuse to let you contribute while repaying a loan.” Smalenberger is the cofounder of Financial Design Studio, a fee-only financial planning and wealth management firm based in Deer Park, Ill., northwest of Chicago. “When an employer chooses what plan they will offer or make available to their employees, they have to choose which provisions they will allow.
“If you can’t contribute while repaying, remember that your employer is giving you a benefit by allowing the loan from the plan in the first place,” says Smalenberger.
And if you can’t make contributions while you’re repaying your loan, be aware that a higher amount of your paycheck will go to income taxes until you resume contributions.
If your employer does allow plan loans, the most you can borrow is the lesser of $50,000 or half the present value of the vested balance of your account, minus any existing plan loans. You must repay the loan within five years. And taking a loan puts you at risk of facing the obligation to repay it within a narrow time limit, typically 60 days or less, if you are laid off or quit.
You asked about borrowing, but it's also important to know about another way you can get money from a 401(k): a hardship withdrawal. Don't confuse them: This type of withdrawal is not a loan; it permanently reduces your account balance. If you make one under certain circumstances, you may not be charged a penalty, though you may owe income taxes. If your employer chooses, it can also refuse to let you contribute to your account for at least the next six months after a hardship withdrawal.
The Bottom Line
When it comes to 401(k) plans, it can be challenging to understand the rules. That’s why it’s important to do your research to figure them out, so your employer doesn't take advantage of you, and you don’t incur any taxes or penalties you weren't expecting.