What is a 401k, should I rollover my 401k when I change jobs, and what do I do with it when I retire? These are some of the most common financial questions that people have about their retirement plan.

This article will explain personal finance strategies and rules surrounding 401k retirement accounts in order to help you make the best decisions with your hard-earned retirement savings.

History of the 401k

The 401k has become an extremely popular type of retirement plan in the United States. A 401k is a defined contribution plan, in which the employee saves a portion of his or her salary each pay period for retirement.

The 401k originated with The Revenue Act of 1978, of which Section 401(k) paved the way for defined contribution plans (Davidson, 2016). Up to this time, most retirement plans were defined benefit plans or employer-funded pensions.

In the early 1980s, the IRS began allowing employees to contribute to their 401 k plans with salary deductions. This started a national shift toward defined contribution plans.

Over the following decades, most retirement plans shifted from defined benefit plans to defined contribution plans. The Pension Protection Act of 2006, intended to protect retirement accounts, further encouraged companies to push employees toward 401ks. In 1990, 43 percent of private company employees were covered by a pension plan; in 2011, 93 percent of employees participated in a defined contribution plan.

There are different types of 401 k plans. The most familiar type is the traditional 401k account, where you contribute pretax dollars and your savings grow income tax-free while they accumulate in your account until withdrawal.

Benefits of the 401k

The 401k offers many benefits for employees. These include:

Easy to Contribute

A key to growing retirement savings is to start early and contribute regularly. A 401k makes it easy to accomplish this with payroll deductions. You can set up your account to make automatic deductions from each paycheck. This makes retirement saving easy and painless. You won’t miss the money, and you’ll feel good about making preparations for a secure financial future.

Tax-Advantaged

401k contributions can help you lower your taxable income for the year because they are made with pre tax dollars. Also, gains and dividends accumulate in the account tax-free until withdrawn.

Protection From Creditors

If you ever have financial difficulties, you’ll appreciate that your 401k is generally protected from creditors(Investopedia, 2019). They also offer some protection against federal tax liens.

Longer Contribution Term

Unlike some retirement plans, you can continue to contribute to your 401k as long as you’re still working. Also, there are no mandatory distributions as long as you’re employed.

Employer Fund Matching

Many employers match the employee’s contribution to the employer’s 401 k plan up to a certain amount, such as $1 or 50 cents for each dollar the employee contributes up to 5 percent of salary. Consider this free money that can help you save for your retirement. Employer matching is an addition to the employee’s salary and is not taxable income.

Potential Problems With A 401k

It is important to understand the potential problems and limitations with a 401k. Here are a few common limitations that may be important to know.

Limited Control

The 401k plan is set by the company and the employee has no control over the terms of the employer’s 401 k plan and its management costs. Unlike other retirement accounts where you can choose where the funds are held, who or how they are managed, and what the account fees are, with a 401k either you are in or you are out. These costs are often higher than other retirement accounts, especially for smaller companies (Wasik, 2020; Alfred, n.d.)

Limited Options

Additionally, your investment options are limited. Unlike an Individual Retirement Account (IRA), you typically cannot invest your 401k funds in individual stocks, bonds, or precious metals due to 401k plan limitations. The average plan offers an array of 19 stock and target-date mutual funds, ranging from conservative to more aggressive (Kiplinger, 2020).

Waiting Period

Often employees must have worked at a company for a period of time before they are eligible to contribute to the company’s 401k.

One-third of companies require employees to have been with the company for at least six months, and a quarter requires employees to have been there at least one year.

Additionally, many companies require employees to have worked at the company for several years to keep all of the matching funds. This is called a vesting period. With some plans, matching funds vest at 25% or 33% each year; with other plans, matching funds vest after three or four years at the company. If you leave the company before the vesting period is over, you do not get to keep all of the matching funds.

Required Minimum Distributions

The terms of 401k accounts mandate required minimum distributions (RMDs) from the accounts starting April 1 the year after you reach age 72. This is true with any retirement account, such as a traditional IRA or a Roth IRA. With some 401k plans, this rule is waived if the employee is still working until the employee actually retires. Additionally, distributions from retirement accounts are taxed as ordinary income with the exception of a Roth IRA or after-tax 401k plans.

Today, there are different types of plans for different types of organizations: 401k plans for private companies, 403b plans for nonprofit organizations, 457 plans for state and local governments, and Thrift Savings Plans for federal government employees and military members.

For smaller businesses with up to 100 employees, the SIMPLE IRA is a tax-deferred retirement account that allows employees to make contributions with employer matching up to 2% or 3%. Contributions are tax deductible and employer matches are deductible business expenses.

Many companies now also offer Roth 401ks. With a Roth 401 k, contributions are not tax-deductible, and there are still RMDs at retirement, but distributions are not taxable if you’ve held the account for at least five years. A Roth 401 k may be advantageous for those who expect to be in a higher tax bracket in the future.

If you’re self-employed, there are retirement plans for you as well. The Simplified Employee Pension (SEP)-IRA is for self-employed people and small business owners with no or a few employees. It allows you to contribute part of your net earnings from self-employment to a retirement account. You can open a SEP-IRA at a bank or other financial institution and complete a one-page form.

You can also create a one-participant 401k plan if you’re a business owner with no other employees except possibly your spouse. These plans are subject to the same rules as other 401ks. You can contribute to the account in your capacities as both employee and employer (IRS, n.d.).

How to Fund Your 401k Effectively

There are many strategies and thoughts behind how you should fund your 401k. Here are a few thoughts to consider when you are deciding if a 401k is right for you or not.

If you work for an organization that offers a retirement plan, consider yourself lucky. Not everyone does. Over one-third of workers have no plan available to them (Martin, 2018).

If your company offers a 401k with contribution matching, consider taking full advantage of this “free money”. One of the most common mistakes people make is not partaking in the employer match. Although more than half of workers are offered a 401k, only 32 percent participate, according to the Census Bureau.

In 2021, you can contribute up to $19,500 per year into your 401k account through salary deferral contributions. This is on top of any matching funds from your company. If you’re age 50 or over, you can contribute an additional $6,500 for a total contribution limit of $26,000.

Before you contribute to your 401k, make sure to consider the benefits and limitations of those funds. Remember, these funds for the most part cannot be used without penalty until you are 59 ½ years old. When contributing, you are able to place those funds in the 401k and do not have to pay taxes, but you will have to pay taxes when they come out. Consult your plan administrator for specific information about your company’s 401k plans.

A good question to ask is “do you believe you will pay more in taxes today if you took it as income or would you pay more in the future when you retire?” Keep in mind that federal income tax rates are historically low (Bradford Tax Institute, n.d.) and may rise in the coming decades. Also, consider that in retirement you may choose to move to a state with a different state income tax rate or no income tax at all. Consult a tax advisor with questions about your tax situation.

What to Do When You Change Jobs

If you have an old 401 k and retire or change to a new job, you may be wondering what to do with your retirement funds. You do not have to roll it over to your new employer or to an IRA, and there may or may not be advantages to doing so.

Generally, your options for your old 401 k are:

  • Leave it with your former employer
  • Roll it over to an IRA
  • Roll it over to your new employer’s plan
  • Take distributions
  • Cash it out (not recommended due to the potential tax liability)

Leave It With Your Former Employer

If you have over $5,000 in your 401k, normally you can leave it with the company. You can no longer make new contributions to it, but the existing funds can continue to grow tax-deferred.

If you have $1,000 to $5,000, the company will most likely help you transfer it to an IRA. If you have less than $1,000, the company will most likely have you cash it out and issue you a check.

If you are satisfied with your former employer’s plan, its performance, and range of investment offerings, then leaving it at the company may be an appropriate option.

But if you’re likely to forget about the account down the road, or you can get better investment choices or lower account fees elsewhere, then rolling the funds over after you start your new job may be a better course of action.

A disadvantage of leaving your 401k with your previous company is that you’re limited to the investment choices offered by that company. Also, your account is subject to the terms and fees of the 401k plan, which you may no longer keep up with since you’re no longer an employee there.

Another consideration is whether you borrowed from your 401k. If so, you must repay the loan to an IRA by contributing the borrowed amount to the IRA. You must complete this process by the tax return deadline of the following year.

If you don’t repay the loan by the deadline, the plan will take funds out of your account to recoup the loan. These funds will count as taxable income and, if you’re under age 59 ½, you’ll also pay a penalty of 10 percent of the borrowed amount.

Rollover 401k to IRA

A traditional IRA or Roth IRA account can be an attractive choice compared to leaving your 401k behind or rolling it over to your new company. This is because IRAs typically offer more investment choices and lower account fees than 401ks. This is especially true for smaller companies.

Larger companies, on the other hand, often have access to institutional rates that are lower than an IRA. Because large companies manage 401ks for so many employees, they can negotiate lower rates.

If you rollover to an IRA, you have to be careful to avoid receiving a distribution from your 401k. This would be taxable income, and you would also incur a penalty if you’re under age 59 ½.

To avoid this, have the new account (e.g. a traditional IRA) created and ready to receive the funds from the 401k. Have a check made out to the IRA account custodian, like Schwab or Fidelity, for the benefit of you (FBO), not to you directly (O’Brien, 2021).

As the IRA owner, you’ll need to have some investment knowledge to decide when and where your funds are invested. IRAs are often managed by brokerage services and offer a vast array of investments to choose from including stocks, bonds, and mutual funds. If you don’t already have investment experience, you’ll need to conduct some research or consult a financial advisor.

Another consideration is that in California and some other states, there is greater creditor protection for 401ks than for IRAs. This could be important in case you have financial difficulties.

If you had less than $1,000 in your old 401k and your previous company sent you a check, you should deposit this into another retirement account within 60 days, or you will owe taxes and you may also incur an early-withdrawal penalty of 10 percent of the funds. The company will already have taken out 20 percent as taxes by law before sending the check to you. If you roll over the funds within the time limit, the withholding will be returned to you when you file your tax return for the year (FINRA, n.d.).

Roll It Over To Your New Employer

Not all retirement plans are required to accept rollover contributions. But if your new company offers a better retirement plan and you’re eligible to contribute, it may make sense to rollover your old 401k account to a new account at your current company.

It’s simple to rollover your old 401k to a new account: the plan administrator of the old plan deposits the funds from your old plan to your new one. This is called a direct rollover and prevents you from owing any taxes or penalties.

If you have 401ks from multiple previous employers, consolidating them into one 401k at your present employer can simplify your finances.

Another thing to consider: funds in the 401k of your current employer may not be subject to required minimum distributions (RMDs) if you’re still working, depending on your plan. However, funds in the plans of previous employers are subject to RMDs.

Remember, a downside of rolling your 401k to your new company is that your savings are subject to the restriction and account fees of the new employer’s plan. These may be better than those of your former employer’s plan. Also, your 401k typically has fewer investment options than are available with an IRA, and, depending on the company, may come with higher management fees as well.

Take Distributions

If you’re in or close to retirement, this might be the option for you. After all, this is what your retirement savings are for – to help fund your expenses and lifestyle.

You can take distributions from any 401k, old or present, after age 59 ½ without early withdrawal penalties. As mentioned earlier, you must take RMDs from your 401k if you’re age 72 or over and retired.

And if you retire or lose your job, and you’re at least age 55 but not yet 59 ½, you can also take distributions penalty-free from the 401k at the employer you just left (but not earlier employers). This strategy can be technical, so it is recommended to run it by a financial professional or tax advisor who can guide you.

If you’re under 59 ½, you can take also a distribution from your 401k without a penalty under certain conditions, including:

  • The distribution is made after you leave your job, and you left the company in or after the year you turned age 55
  • The distribution is made because of a qualifying disability
  • To pay for medical care up to the amount allowable as a medical expense deduction
  • Because of certain declared disasters for which IRS relief is available

Distributions from traditional 401ks are taxable, so if you expect your tax bracket, or tax rates in general, to be higher in the future you might consider taking distributions earlier instead of waiting.

Cash It Out

You can simply liquidate your 401k as a lump-sum distribution, but this may be the least desirable option in most cases. Unless you deposit the funds in another retirement account within 60 days, all of the funds you’ve saved will be taxed as income. If you are younger than 59 ½ years old, you will also incur a penalty of 10 percent of the total funds in addition to your income tax.

Moreover, by cashing out your retirement savings, you’ll lose the opportunity for your savings to grow tax-deferred (or tax-free for a Roth 401k). This strategy is not recommended.

Conclusion

The 401k is a useful way for workers to save for retirement with tax benefits and employer matching. It has some disadvantages compared to other retirement options like an IRA account. But it provides a relatively easy way for workers to save for retirement who might not otherwise.

You have many options regarding your 401k when you retire or leave your job.

Because the regulations and tax laws are complex, and everyone’s situation is a little different, we encourage you to consult your 401k plan administrator or a licensed financial advisor with questions about your plan and about what to do with your 401k funds.

Written by Maxwell Chi

References:

Alfred, R. (n.d.). The One Chart that Explains 401(k) Fees. https://www.brightscope.com/financial-planning/advice/article/15556/The-One-Chart-That-Explains-401K-Fees/
Bradford Tax Institute (n.d.). History of Federal Income Tax Rates: 1913 – 2021 https://bradfordtaxinstitute.com/Free_Resources/Federal-Income-Tax-Rates.aspx
Davidson, L. (June 21, 2016). The History of Retirement Benefits. https://www.workforce.com/news/the-history-of-retirement-benefits
FINRA. (n.d.). 401k Rollovers. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/401k-rollovers
Investopedia. (November 6, 2019). Can a Creditor Seize My Retirement Savings? https://www.investopedia.com/ask/answers/07/seizing-savings.asp
IRS. (n.d.). One-Participant 401(k) Plans. https://www.irs.gov/retirement-plans/one-participant-401k-plans
Kiplinger. (February 24, 2020). How Much Can You Contribute to a 401(k) for 2020? https://www.kiplinger.com/article/retirement/t001-c000-s001-how-much-can-you-contribute-to-a-401-k-for-2020.html
Martin, E. (March 12, 2018). Here’s how many Americans don’t have access to a 401(k) plan. https://www.cnbc.com/2018/03/12/how-many-americans-dont-have-access-to-a-401k.html
O’Brien, S. (January 4, 2021). Avoid these costly mistakes when rolling over a 401(k) to an IRA. https://www.cnbc.com/2021/01/04/avoid-these-costly-mistakes-when-rolling-over-a-401k-to-an-ira.html
Wasik, J.F. (July 11, 2020). At a Time of Financial Stress, 401(k) Fees Matter More Than Ever. https://www.nytimes.com/2020/07/11/business/401k-advice.html