What Happens to Your 401(k) When You Quit Your Job?

Question: What happens to your 401(k) when you quit your job or switch to a new one?

Your retirement security used to be a BIG consideration when it came to changing employers.

In the old days of pension plans, if someone were to quit their job early, they could be potentially giving up life-long future monthly checks worth thousands of dollars!

But that was then, and this is now.  According to the website The Balance, the average person changes jobs 10-15 times during their career.

What changed?

A lot.  But in terms of the future of your retirement savings, a big influence was the shift away from the pension system towards the 401(k) plan.

Though its often a heated debate, there are many aspects to a 401(k) plan that make it more attractive than a pension plan.  And one of those points is that fact that your money follows you wherever you go.

In this post, I’d like to clear up any misconceptions you have about what happens to your 401(k) after you’ve left your job, and what your options are for keeping it growing for a long and successful retirement.

Your 401(k) Contributions and Vesting

The first thing you need to know about your 401(k) after you’ve quit your job is that as long as you’re “fully vested”, nothing will happen.  All of the money that you put into your 401(k) (i.e. your contributions) and all the earnings that grew on top of it all legally belongs to you.

When it comes to your contributions and earnings, the catch here, of course, is whether or not the investments you’ve picked for your 401(k) have lost any money. Think back to the Great Recession of 2008 when the market sank approximately 40%. If you had saved $10,000 in your 401(k) the year before, your 401(k) balance probably would have been reduced to a disappointing $6,000 – Ugh!

So what’s the biggest way people lose money in their 401(k) when they switch from one job to another? It’s the portion that your employer contributed, and this will due to something called “vesting”.

Vesting is the set of rules set forth by your employer that determines when their contributions to your retirement plan become yours.  Here’s a whole post we wrote that breaks down how vesting works.

For example, if your employer requires you to work for at least 2 years before you’re fully vested and you’ve only worked one year, then you’ll likely lose some or all of the money that they’ve contributed.  Suppose you worked 3 years.  Then in this example, you’d be okay.

Every employer can and likely has a different set of vesting rules.  The only way to know for sure is to talk to your HR department and find out for sure.

What To Do With Your 401(k) After You’ve Left Your Job

Okay.  So now that you know how much of your 401(k) you’re entitled to.

The next question is what exactly to do with all of it.

This is both the privilege and burden of 401(k) plans.  The money is under your control, but it’s up to you to figure out how to best manage it.

That responsibility is not without its potential pitfalls.   Make the poor choice, and you could end up paying thousands of dollars in taxes or penalties that you had no idea that you’d owe!

Let’s explore the options and weigh the pros and cons of each.

1- Roll It Over Into an IRA

One of the easiest ways to manage your retirement savings after you’ve quit your job is to simply move it into an IRA.  This is commonly called “rolling it over”.

Personally, this is my favorite option because:

1. The fees will likely be less. Remember that with 401(k)’s, you not only pay expense ratios on the funds themselves, but you also pay administrative fees that come along with maintaining the 401(k) plans.  With an IRA, you don’t have administrative fees.  And if you go with a super low-cost provider like Vanguard or Fidelity, then there’s a very good chance you’ll also pay much less in fund expense ratios.  I’ve seen index funds priced as low as 0.05%.  That’s $5 for every $10,000 you’ve got invested!
2. You’ll likely have better investment options. Remember that with a 401(k), you’re only allowed to pick whatever funds the plan offers.  With an IRA, you can set it up anywhere you want and choose to invest in just about anything.
3. It gives you the most control over your money. With 401(k)’s, in order to access your money (for loans or early redemption), you have to get permission from the plan administrator (i.e. your old work).  Who wants to do that?  If you move your money into an IRA, then you’re now the boss.  You get control over these decisions.

A rollover can be done with virtually any financial institution of your choosing.  It can be the company you already have an IRA with, the former company that hosted your old 401(k), a completely different company altogether, etc.  You get to decide.

Usually there are little or no fees associated with rollovers.  Financial institutions see this as an opportunity to receive a large sum of money all at once, and so they usually try to make the transition as easy and painless as possible.  Some even offer bonuses to try to entice new clients!

Watch-Out!  If you’re going to roll-over your old 401(k) into an IRA, don’t mix up going from a Traditional to a Roth account.  Keep it the same (Traditional to traditional, or Roth to Roth).  If you cross over from one style to another, you could end up owing taxes … potentially LOTS and LOTS of taxes.

For example, say you had $100,000 in a traditional 401(k) and tried to roll it over into a Roth IRA.  You might be looking at a $25,000 tax bill!  Ouch!

2- Rollover Into Your New 401(k)

Another common option for managing your old 401(k) after leaving your job is to simply move it into your new employer’s 401(k) plan.

This isn’t necessarily a bad option if your new 401(k) offers great fund choices with low expense ratios.  Plus, it makes it easy to see all your money in a one-stop-shop.

But there is no financial gain for doing this.  You won’t receive any special employer matching or contributions for doing so.

And don’t forget you’ll still be paying an administrative fee for the plan itself.  With the IRA option, you can avoid this.

3- Leave the Old 401(k) Right Where It Is

You can opt to do nothing with your old 401(k) and leave it right where it is.

Again, the money is yours.  So whether you collect it now or 5 years in the future, it doesn’t matter.  Plus, if you’re happy with the fund performance, fund choices, and fees, then there is no harm.

However, my fear with this option is that it allows your money to become “out of sight, out of mind”.  That’s not something you want to happen with your retirement savings.  You should check in your 401(k) from time to time (at least once per year) and make adjustments where it’s needed.  Your future cash-flow is not something you want to neglect.

4- Cash-Out

The final option when you quit your job is to simply cash out your old 401(k).

Though this can be a very tempting option, even if you intend on doing something very sensible with the money, I STRONGLY recommend that you do NOT do this!  

The first problem is that you’ll owe taxes.  Suppose you’ve got $10,000.  Suddenly, you’ll end up owing approximately $2,500 in taxes that you weren’t expecting.

The second problem is that you’ll also owe a 10% penalty for withdrawing your money before age 59-1/2.  Again, if you’ve got $10,000, that’s $1,000 gone – just like that!

Finally, it defeats the purpose of saving for retirement if you cash out your money.  All the potential power of compounding returns and years of saving are erased, and your future is at risk.

Again: Know this option, but more importantly know the reasons why its not the right choice for you.

Readers – What did you do with your 401(k) after you quit or changed jobs?  Which option did you find to be best and why?

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