Leaving your employer? Consider your 401(k) plan options

If you're like many people today, you’ve been affected by a job loss — either directly or indirectly through family and friends. Although deciding what to do with your employer-sponsored retirement plan isn't a top priority when going through a job loss, once the dust settles and your more pressing needs have been addressed, it's time to weigh your 401(k) options.

The rules around vesting

Once you leave your job, either voluntarily or involuntarily, you're entitled to the vested balance on your retirement account. Your vested balance includes your own contributions (pretax, after-tax and Roth) and any investment earnings on those amounts. It also includes employer contributions and earnings that have satisfied your plan's vesting schedule.

In general, you are 100% vested in employer matching contributions after three years of service (cliff vesting), or you begin with 20% vesting in the second year and end with 100% after six years (graded vesting). There are more restrictive vesting schedules that can be elected for non-matching employer contributions, such as profit-sharing plans. Other plans have 100% immediate vesting. You are also 100% vested when you reach your plan's normal retirement age.

Special vesting rules apply to some plans, so make sure you understand how your particular plan's vesting schedule works.

Weighing your 401(k) options

In most cases, your former employer's retirement plan is a "tax qualified" plan, which simply means the plan qualifies for special tax treatment. In general, with this type of plan, you have four options when you leave your job:

• Leave your money in your former employer's retirement plan.
• Move your money into a new employer's plan.
• Take the money in cash.
• Roll your money into an IRA.

Leave it

There are pros and cons to leaving your retirement assets in your former employer's plan.

Pros

• You're already familiar with how the plan works.
• Growth of your assets is tax-deferred.
• Money in your 401(k) is shielded from most creditors.
• You are entitled to penalty-free distributions if you lose your job in the year you turn 55 or later.
• You may get better tax treatment if you have a distribution of appreciated company stock from your 401(k).
• Typically, you won't be charged fees for trading within the account, or for mutual fund loads or commissions.
• Your investment expenses may be relatively low due to institutional pricing.

Cons

• You may have more limited investment options.
• You may have less flexibility to access your money or change your allocations.
• There are fewer exceptions to the 10% early withdrawal penalty (e.g., you can't take penalty-free money out for education expenses or health insurance premiums if you're unemployed, nor can you withdraw up to $10,000 for a first-time home purchase).
• Beneficiary choices may be more limited.
• There's a mandatory 20% withholding on some distributions.

Other considerations

• If you decide to leave your plan where it is, be sure to tell your former employer.
• If you have $5,000 or less in your plan and you don't make an election shortly after you leave, your employer can choose to remove your assets from the plan and process a direct rollover to an IRA the employer selects for you. And if you have $1,000 or less, your employer can choose to distribute the funds to you, which could result in tax penalties.
• If you've taken out a loan against your retirement plan, you usually need to repay it before you leave the company.

Move it

If you already have a new job in the wings and your new employer offers a retirement plan, you may opt to make a complete break with your former company and consolidate your assets into one plan.

Pros

• Your money and any growth are tax-deferred, with no current taxes or penalties, if you move directly from your existing plan to a new qualified plan.
• Your money stays shielded from creditors.
• You're entitled to penalty-free distributions if you lose your job in the year you turn 55 or later.

Cons

The cons for this option are the same as those for leaving your account with your former employer. These include having limited investment options, less access to your money and reduced flexibility to make changes.

Plus, if you've made after-tax contributions to your current plan, you'll need to find out if your new plan accepts them and whether you can separately account for after-tax contributions.

Before you move your plan to a new employer, make sure to ask the new plan administrator the following questions:

• What are the new plan's investment options?
• What are the loan and withdrawal privileges?
• What is the waiting period, if any, to move the money from the existing plan?
• Are the account fees for the new plan higher or lower than those for the current plan?

Also, make sure you read through the summary plan description of both the old and new plans before you make your decision.

Take it

When you're going through a job transition, it can be tempting to just take the money from your retirement plan so you have extra cash on hand. But while this pool of money may look attractive, you shouldn’t take it unless you absolutely need to. In fact, many experts on retirement plans agree that most people should not cash out their employer-sponsored accounts — even if they are no longer an employee.

Why? Because there are no pros to taking the money, except gaining access to cash to potentially cover a critical need — and even then it should be a last resort. However, there are plenty of cons to this option.

Cons

• If you take a full distribution, you'll be taxed at ordinary income tax rates on any pre-tax contributions and earnings in your account. After-tax or Roth 401(k) contributions you've made are not taxable, nor are qualifying earnings in a Roth 401(k).
• If you were not age 55 or older in the year you left your employer, an additional 10% penalty may also apply to the taxable portion of your payout.
• Growth of the money will no longer be tax-deferred.
• By taking the distribution early, chances are slim that this money will be available to help fund your retirement because you will have found some other use for it by then.          
• If you do take a distribution, your former employer is required to withhold 20% for taxes.

Roll it

If you want more control of your retirement dollars and greater flexibility, rolling over your 401(k) into an IRA may be the right choice for you. Here are a few additional reasons to consider this option.

Pros

• The account is yours and no longer connected to your former employer.
• There are no "blackout" periods when you are not allowed to trade or take distributions from the account, as can occur with a 401(k) plan.    
• An IRA provides a greater range of investment options — including stocks, bonds, managed accounts, real estate investment trusts (REITs) and mutual funds — than most employer retirement plans.
• You typically have greater flexibility to make changes and access your money, unlike some employer-sponsored plans that only allow for lump-sum distributions or don’t allow you to take out money as you please.
• Growth continues without current taxes or penalties.
• You may have greater flexibility with your beneficiary arrangements.
• There are more exceptions to the 10% early withdrawal penalty. For example, you can make withdrawals for education or to cover health insurance premiums if you’re unemployed, or take out up to $10,000 for a first-time home purchase.
• There isn't a mandatory 20% withholding on distributions from IRAs, unlike employer-sponsored plans.

Cons

A few possible disadvantages for this option include:

• You have to be 59½ to withdraw money without a tax penalty unless another exception applies.
• IRA assets that are rolled over from a qualified plan are protected from creditors in the event of bankruptcy; however, if creditors are trying to gain access to the IRA assets outside of bankruptcy, it is a matter of state law. 
• If you have stock in a company plan that has appreciated in value, you will lose favorable tax treatment on the net unrealized appreciation (NUA) if you roll the employer stock to an IRA.
• Fees may be higher with an IRA and you may have to pay for trading as well as for mutual fund loads or commissions. Any applicable IRA fees will be disclosed in the product prospectus, contract, offering or other disclosures you receive.

Take control of your financial future

Your workplace retirement plan may be one of your most significant assets, which means it could play a big role in helping you reach your long-term financial goals. This is why it's so important to make wise decisions about your 401(k) plan today.

By taking the time to evaluate your options, with help from your financial advisor and tax consultant, you can more effectively make sound decisions — and take control of your financial future.