In today's job market, switching employers every few years has become more common.
The median amount of time American workers spend at a single job is fewer than five years, according to data from the U.S. Bureau of Labor Statistics. And Baby Boomers hold an average of nearly 12 jobs over the course of their careers, the data show.
Switching jobs often triggers a decision: What to do with the 401(k) account from your previous employer?
Here's a look at a few of your options and how they work:
Don’t Change a Thing
If you like your former employer's 401(k) plan, you may be able to keep your money parked there. But staying with the same plan will mean some changes.
As a former employee, you won't be able to make additional contributions to the account and you may also give up the option of taking a loan from the plan. And some companies will stop paying certain fees for former employees who remain in the plan, which might mean an extra cost to you.
Not all ex-employees are eligible to hang on to their old 401(k) accounts. If the value of your account is below certain thresholds, your former employer may require you to take a cash distribution or it may automatically roll your savings into an IRA.
To avoid unexpected distributions or rollovers, be sure to check your former employer's rules regarding retirement savings accounts.
Rolling Over Your Account to Your New Employer
If you like the investment options in the 401(k) plan offered by your new employer and are comfortable with the fees that plan charges, you can roll over your old account to your new employer's plan if they allow rollovers into the plan.
There are two ways to go about doing this — through a direct rollover or through an indirect rollover.
In a direct rollover, that money never passes through your accounts. Instead, you arrange for the rollover with the administrator of the new plan, including filling out all necessary paperwork, and contact the administrator of your former employer’s plan and ask that he money be sent directly to the administrator of the new plan. That might mean your old plan provider cuts and mails you a check made out to your new plan administrator. In that case, you’ll be responsible for mailing that check onwards.
In an indirect rollover, you receive a cash distribution from the administrator of the former employer’s plan, and it's your responsibility to ensure your retirement savings wind up in your new plan within 60 days. This approach leaves you vulnerable to a tax hit and penalties if you don’t do so within a set amount of time. For this reason, a direct rollover is the safer option when it is available.
Under IRS rules, employers must withhold 20 percent of the taxable portion of that distribution — just the earnings for a Roth 401(k) and all earnings and contributions for a traditional 401(k) — in the event you don’t deposit that cash in a new tax-advantaged retirement account within 60 days. Remember, traditional 401(k) contributions are made pre-tax.
If you do make that rollover within that 60-day window, that 20 percent withholding will be returned to you. If you don’t make that 60-day window and you are younger than 59½, you may also be subject to a 10 percent penalty.
To avoid tax consequences and penalties, you’ll have to contact the administrator of your new employer's plan to set up and deposit funds into your new account equaling the amount in your old account before the 20 percent IRS withholding by your former employer is returned to you. This means you'll need to find another source of funds to make up for the IRS withholding.
For example, if you are indirectly rolling over $10,000 from your former employer’s traditional 401(k) plan, you will only receive a check for $8,000. You must deposit the additional $2,000 yourself, out of pocket, within 60 days to avoid a 10 percent tax penalty.
Rolling Over Your Account to an IRA
Want to invest your retirement savings but don't like the investment options or other aspects of your employer plan? You can choose to roll over your 401(k) into an Individual Retirement Account, or IRA, another kind of tax-advantaged retirement account. This rollover can also be direct, or indirect.
Before you take the plunge, however, be cautious: you should have an understanding of all the factors involved, including the fees associated with an IRA, and of all the potential tax consequences.
For more about IRAs, check out this primer.
The nature of your old 401(k) determines what type of IRA you’ll need to move your funds into. Converting a 401(k) into an IRA can be accomplished without paying new taxes if your IRA type matches your 401(k) — that is, if you roll a traditional 401(k) into a traditional IRA and a Roth 401(k) into a Roth IRA.
A rollover will be subject to taxes, however, when it entails moving from a traditional 401(k) into a Roth IRA in what is known as a Roth conversion.
In a Roth conversion, you pay taxes on your funds when you make the switch, but you eliminate federal income tax on future withdrawals. Whether this is a good idea or not depends on whether you expect your tax bracket at the time of the conversion to be higher or lower than when you start taking withdrawals. Make sure to check whether your 401(k) plan permits a Roth IRA rollover before setting your sights on this option.
Once your IRA is established, you may continue making contributions until age 70 1/2, provided that you're continuing to earn income and your contributions don't exceed annual limits set by the government.
Deciding against a rollover and asking your 401(k) plan administrator to cut you a check is a common, but costly practice.
By law, your former employer will withhold 20 percent of your funds and apply them to taxes. And you might be subject to additional taxes on top of that 20 percent withholding depending on your tax bracket. In addition, if you're younger than 59½ when you cash out, you'll likely be subject to a 10 percent early withdrawal penalty.
All in, that means a significant portion of your 401(k) savings could evaporate and that fat check you thought you'd get might prove uncomfortably thin.