When you leave a job, you're initially focused on the most impactful part of the change- finding or starting your new job. But there are other things you'll need to deal with, such as replacing health insurance, making sure you have enough life insurance, and deciding what to do with the retirement account from your former employer. Below is what you need to know about the latter so you can make an informed decision.
Generally speaking, when you leave your employer, you have three options for what to do with the old account.
- Leave it where it is.
This is what many people default to, at least at first. It feels like it's putting off making a decision, but it it actually IS a decision- a decision to continue using the current custodian, which may not be the best fit for you. Keep in mind that the benefits of that plan- the ability to contribute to it, the ability to take a loan against it (for some plans)- those benefits actually go away when you don't work for the company anymore. I've seen many clients feel scattered because they have made this choice more than once, and now their finances feel scattered.
One thing to be aware of on the "for" side of keeping it where it is is that 401(k)s and other employer-sponsored retirement plans may be federally protected in a lawsuit, whereas IRA protections are managed at the state level, and may be used to pay for damages. SIMPLE IRA's would fall into the same bucket as IRA's here. But I'd argue that for most people, having umbrella coverage would cover this risk more effectively.
- Cash it out.
Cashing your 401(k) out is almost never recommended, especially if you're under age 59 1/2; "pre-retirement distributions" are subject to a 10% penalty, in addition to all pre-tax dollars being fully taxable. If you're in the 24% tax bracket, you'd basically give about a third of the account straight to the IRS. 😬 Keep in mind that distributions count as taxable income, in addition to your earned income, and may push you into a higher tax bracket than the one you're currently in.
- Move it somewhere else.
This makes the most sense for a lot of people, as there are multiple choices within this option. You may be able to roll it into your new employer-sponsored plan, which will feel super consolidated. You may choose to move it to a DIY platform and manage it yourself. Or you may choose to transfer it to a financial advisor's management. Typically, financial advisors will cost more than investing in something like a target fund or an index fund, but they will provide services beyond investment management. These services could include anything from teaching you about investments, helping you make other important financial decisions, planning for retirement, or simply avoiding costly mistakes.
Things to keep in mind
- You will want to be sure that any movement of funds is "like to like", such as a Traditional 401(k) to a Traditional IRA, or a Roth 403(b) to a Roth IRA. So long as you move your pre-tax investments into another pre-tax account, the movement of funds should not be taxable.
- If you move your 401(k) into an IRA, this is considered a rollover. With an indirect rollover, the 401(k) custodian sends the funds straight to your new custodian. Most 401(k) custodians I've interacted with do indirect rollovers, meaning they send the check to you, the participant, then you are responsible for ensuring it is deposited in the new account. Keep in mind you have 60 days to deposit those funds, or they may be considered as being cashed out. 😳
- SIMPLE IRA's have a special IRS restriction, known as the two year rule. Before transferring a SIMPLE IRA account, you'll want to confirm when your initial contribution went in. That contribution starts a two year window, and if you transfer the account during that window, the account will be subject to a 25% penalty, even if it's being transferred to a like account. You'll likely want to wait to move it until the two year window is reached.
- Vesting refers to how much of the employer's contributions you are eligible to keep when you leave that employer. Vesting schedules are different from plan to plan, typically falling into one of two categories:
- Graded vesting refers to a gradual, incremental vesting over some period of years. For example, your company may have a 3 year vesting schedule. If you leave in year 1, you get none of the employer contributions, if you leave after a full year you get 33%, after 2 years you get 67%, and if you've worked the full 3 years, you get 100% of the employer contributions.
- Cliff vesting is more of an all or nothing approach. If you had a 3 year scheduled with this type of vesting, you could work for the employer for 2 years and 11 months, and get 0% of the employer contributions. If you worked there for one more month and hit the 3 year mark, you'd get 100% of the employer contributions. Ideally, you'd understand vesting before setting your final day on the job.
- SIMPLE IRA's do not have vesting schedules, just see the above description of the two year window.
Whatever you decide, you'll likely want to at least consult a Financial Advisor to be sure you make an informed decision when you decide what to do with your old 401(k) or other employer-sponsored retirement plan. Good luck with your job change!