Beginning a new job is a time of transition, and there's already a lot on your plate. You need to get a handle on your new role, of course, but you'll also have to make some updates to your retirement savings strategy.
One of the biggest things you must decide is what to do about any 401(k) funds you have from your previous employer's plan. You have a few options, but there's one that'll almost certainly come back to bite you.
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What happens when you leave an old 401(k) behind?
The personal contributions you made to your 401(k) are yours, no matter what. Usually, that money will remain in your 401(k) under your previous employer's plan until you do something about it. Your investments can continue to grow, but you can't make any more contributions to the account. And you should be aware of any fees that could eat into your returns over time.
However, if you have an account balance between $1,000 and $5,000 (or $7,000 starting in 2024 due to recent legislation), your former employer can move your funds to an IRA of their choosing and close your 401(k) account. They will notify you if this occurs, and you can always move that money elsewhere if you prefer.
If you have less than $1,000 in your 401(k) when you leave the company, your former employer can simply cut you a check for the funds (more on this below). You can also choose to cash out your old 401(k) regardless of the balance, but that's usually a bad idea.
What's wrong with cashing out your 401(k)?
Cashing out your 401(k) is problematic because the IRS considers it a distribution from your account. Most 401(k)s are tax-deferred, which means you get a tax break when you make contributions, but you owe income taxes on your withdrawals. You'll also pay a 10% early withdrawal penalty if you're under 59 1/2 at the time.
So, for example, let's say you have $900 in your old 401(k), and your previous employer decides to send you a check in that amount. As a result, you'll have $900 of income added to this year's tax bill, plus another 10% ($90) tacked on as an early withdrawal penalty.
This might not seem like major problem when your 401(k) balance is relatively low, but many people could owe taxes and penalties adding up to tens of thousands of dollars if they cash out prematurely.
But there's a way to avoid this situation -- the indirect rollover. If you put your 401(k) distribution into a new 401(k) or IRA within 60 days, the IRS won't count it as a withdrawal, and you can avoid those taxes and penalties.
This is definitely the way to go if you cash out your old account without knowing the repercussions. But there's another option that's even better if you can swing it.
Could a direct rollover benefit you?
A direct rollover is where you choose to roll your 401(k) funds over into a new account in your name. But rather than handling the money directly, you notify your old 401(k) plan administrator of where you'd like the funds sent, and it handles the transfer for you. There's usually a small one-time fee associated with this.
You can often roll your old 401(k) funds into the 401(k) plan at your new job. However, not all companies allow this, so check with your employer first.
Otherwise, you can also roll the funds directly into an IRA yourself, giving you greater freedom to invest that money how you want. And since the IRA isn't connected to any employer, so you won't have to worry about moving that money again if you switch jobs.
In most cases, there's no need to decide what to do with your old 401(k) on day one of your new job. Just don't wait too long -- the more time that goes by, the greater the chance you could forget about taking the necessary steps to manage this important source of retirement savings.
