What Clients Changing Jobs Should Know About Their 401(k)

Expert Opinion November 06, 2024 at 02:21 PM
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What You Need To Know

  • Many employees make infrequent decisions with respect to their 401(k)s.
  • Rolling employer-plan dollars into an IRA allows for aggregation.
  • Employer-sponsored 401(k)s often require loan repayment over a relatively limited period of time.
Robert Bloink and William H. Byrnes

Increasingly, the American workforce has become more mobile. And while employer-sponsored 401(k) plans are a common employment benefit, it's also common for employees to move between jobs.

These factors collide to leave countless individuals faced with an important decision: whether to leave their funds invested in a former employer's 401(k) or to move their funds to an individual retirement account. 

Because of auto-enrollment and automatic payroll deductions for elective deferrals, many employees make infrequent decisions with respect to their 401(k)s. The decision is an important one — and one that shouldn't be rushed. Careful consideration should be given to the differences between the two most common versions of the traditional retirement savings account when deciding whether to leave funds in a former employer's retirement plan.

Ultimately, the choice between a 401(k) and IRA is a personal one that must be based on an analysis of the taxpayer's individual financial situation. Regardless of the facts, individuals should evaluate all relevant factors when deciding to leave funds within a retirement account.

Investment Options

Investment choices and fees are often key considerations when deciding whether to leave funds within an employer's retirement plan. Typically, employer-sponsored plans offer a concrete, and often limited, set of investment options. IRAs, on the other hand, can offer a virtually unlimited investment menu.

The array of investment options offered within an IRA can make that account more valuable for taxpayers who wish to take a more active management role in their retirement investments.

Individuals should consider the level of service that an IRA will provide. Many participants in 401(k)s allow their funds to be placed in default investments, and that can be valuable for individuals who prefer a more hands-off approach. 

Of course, individuals should also request information about the fees associated with both types of retirement accounts. 

Employees who move jobs frequently may also find the IRA rollover option attractive. Rolling employer-plan dollars into an IRA allows for aggregation, so the individual would have fewer accounts to track. Eventually, aggregating retirement dollars within a single plan can make it much easier to calculate required minimum distributions.

Individuals who hold stock in the employer within a 401(k) plan can qualify for favorable tax treatment if the stock is left in the 401(k). After distribution from the 401(k) to a non-qualified account, a sale of the employer stock may qualify for taxation at the taxpayer's long-term capital gains tax rate under the net unrealized appreciation rules.

That's instead of the ordinary income tax rate that would apply to the appreciation on the stock if it was rolled into the IRA and later sold and the sales proceeds distributed.

Access to Retirement Funds

Many individuals have the choice to leave their funds within a former employer's plan or roll the funds into a new employer's 401(k) plan. One key consideration that is often overlooked involves whether the participant anticipates needing access to those funds.

Employer-sponsored 401(k) plans often contain loan options, structured to require repayment over a relatively limited period of time. When it comes to access to IRA funds, taxpayers can essentially borrow against their IRA for a 60-day period once in every 12-month period.

However, if a taxpayer plans to work past the age when distributions become mandatory (age 73), the taxpayer can avoid taking taxable required minimum distributions by leaving the funds in the employer-sponsored 401(k). Unless the plan requires earlier distributions, when participants continue to work and do not own 5% or more of the company, they can avoid taking taxable distributions from a 401(k). 

Distributions from an IRA must begin when the taxpayer reaches the required beginning date (currently 73), regardless of whether the taxpayer has retired. 

Typically, early distribution penalties apply if a taxpayer withdraws traditional retirement funds before reaching age 59.5. A taxpayer who leaves employment once reaching age 55 can withdraw funds from the 401(k) without incurring the 10% penalty for early withdrawals.

It may also be important to consider creditors' access to the retirement account funds. 401(k)s offer stronger protections against creditors in bankruptcy, whereas the amount of IRA funds protected in bankruptcy is always limited.

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