Quitting your job is an emotional exercise, whether it’s a quick angry reaction to a certain situation or a decision made after weeks of contemplation. Either way, it’s not a pleasant experience. There’s a high level of stress involved.
One of the obstacles that prevents many employees from quitting their job is the uncertainty, and with that comes many questions. One of the most important questions that can weigh on your mind is what happens to your 401(k) when you quit? Does the employer keep the portion of it they contributed? Are there income tax consequences if you cash it out?
What happens to your 401(k) when you quit is a complicated question, with many underlying questions to answer as well. Your HR department can usually answer these for you, but then you’d be tipping your hand about quitting. It’s best to research your options before you quit your job. So, what happens to your 401(k) when you quit? Let’s take a thorough look.
How to Manage Your Retirement Savings Plan while Working
Think of your 401(k) plan as a lifetime savings account that you won’t withdraw from until your retirement. Choose investment options that match your age and time until retirement. Younger workers have higher risk tolerance. Older folks don’t.
The company that you work for is the sponsor of your 401(k) plan, but they do not have access to your money once it’s deposited, even if they are the ones putting it in for you. The money is all yours, even if you quit the job or get laid off.
There are maximum contribution limits with a 401(k) and you want to deposit as much money as possible every year to maximize your retirement. In 2020, the maximum annual contribution was $19,500. That’s a lot, but it comes out pre-tax.
If you’ve reached the maximum contribution limit, you might want to diversify your investment options by depositing additional money into an individual retirement account (IRA), which has a maximum annual contribution rate of $6,500.
401(k) contributions are tax deferred, so you’ll have to pay income tax on them when you withdraw. Keep that in mind if you leave a job and choose to cash out your 401(k). The money you receive will be significantly less that the stated balance.
Cashing Out Your 401(k) after a Voluntary Quit
There’s nothing stopping you from turning your 401(k) plan into cash after you quit your job. As stated above, you will have to pay income taxes, but you won’t have to pay an early withdrawal fee. That only happens if you don’t leave your job and need the money.
Of course, if you cash out your current employer’s 401(k) and then go to work somewhere else where they have a retirement plan, you’ll have to start all over. Don’t wait too long. Proper retirement planning requires several years of work.
Cashing out a 401(k) is also known as a lump-sum distribution. Speak to your plan administrator for more details on how that works. There will be a delay between the submission of your paperwork for it and when you actually have access to the money.
Retirement funds are designed to support you in your golden years, but there are times when having money in hand right now is a better option. Early withdrawal with a lump sum distribution of your account balance is okay if you don’t see any other option.
Rollovers to a New Employer’s 401(k) Account
If you leave a job to go to another job and want to rollover funds from your former employer’s 401(k), speak to the plan administrator at your new employer. They will get in contact with your former employer and make the necessary arrangements.
Rollovers are better investment options than cash outs because there’s no tax penalty. The money in your 401(k) account remains deferred and you won’t have to pay taxes on it until you access distributions in your retirement years.
Finding a better position is one of the more popular reasons that people leave a job. Doing this before retirement age is only risky if those people don’t roll their retirement account over. It’s considered prudent planning for the future with tax benefits.
Rollovers to a Traditional IRA or Roth IRA
If the company you’re moving to doesn’t have a 401(k) or you’re not planning on moving to any company, rollovers to a traditional IRA or Roth may be better investment options for you. These are both retirement savings accounts, but not like your old 401(k).
The main difference between a traditional IRA and a Roth IRA is that the contributions for a Roth are made after taxes, meaning that distributions will be tax-free in your retirement. Traditional IRAs typically employ pre-tax contributions, like a 401(k).
Your former employer’s 401k plan can be rolled into an IRA and not affect the annual contributions limit. The rollover process, however, may cause that money to be classified as income, limiting future contributions during that calendar year.
This is where you should seek professional investment advice. Go over the withdrawal rules for both traditional and Roth IRAs. Ask your investment advisor if they have a recommendation for the best rollover IRA. They can help you make the right choice.
Avoiding Taxes and/or an Early Withdrawal Penalty
Prematurely withdrawing funds from your retirement account could result in a penalty fee from the IRS. Expect that to happen if you decide you need access to your 401k money right after you leave your old employer. You can avoid that by doing a rollover, which is a more tax-efficient strategy.
There are instances where departing employees are allowed to continue using their former employer’s 401k plan after they leave. It’s rare for workers who quit, but some companies have a policy in place that allows it. Check that before you go.
Americans, despite what you may read on the internet, do not have the option of avoiding taxes altogether, but you can minimize current tax liability with a deferred retirement plan. That puts off the tax burden until after age 59 ½.
An added benefit to waiting for retirement before taking distributions from those tax-deferred accounts is that the income tax rate may be lower at that time because you’ll be making less. That’s not always guaranteed, but it’s usually worth taking the chance.