People are often confused about what to do with their 401K assets when they separate from their employer. Should they keep their assets in the plan, transfer to their new employer’s plan, or roll the funds into a self-directed IRA? The answer depends on the needs of the individual and the limitations of the plans, but here are some things to consider.
Keeping the assets in the former employer’s plan could be advisable if there are outstanding loans. Many plans allow the former employee to continue making loan payments if the assets are left in the plan. This would be advisable if there were not sufficient assets outside the plan to pay off the debt.
If the 401k assets are transferred to another plan, it is common practice for the employer to pay off any loans by liquidating 401K assets and transferring the net balance. The problem with this is that funds used to pay off the loan become fully and immediately taxable at ordinary income tax rates, and could also be subject to a 10% penalty if the owner is under age 59 ½.
Another reason to keep 401K assets in a former employer’s plan is if you are age 55 or over and need to start taking income from the plan. Some plans allow for the avoidance of the 10% penalty (which would normally apply to anyone under 59 ½) if the funds are systematically withdrawn over a finite period of time.
Transferring 401K assets to the new employer’s plan might make sense if the new plan allows for loans and you want to keep that option open with a larger available asset pool from which to borrow- not recommended except in extreme emergencies or hardship. Remember, these assets are designed to generate income in retirement and leveraging them could compromise your future cash flow.
The new employer must agree to accept assets from a prior employer’s plan, so this is not always an option.
For many people, rolling 401K assets into a self-directed IRA is a good idea. All 401K plans have administrative expenses, which are typically passed through to the employee. By rolling into a self-directed IRA, you can avoid plan fees and potentially enhance your return.
In a self-directed IRA, you have more control over your investment choices, whether you manage the funds yourself or work with an advisor. Many 401K plans have limited mutual fund investment options, which may be sufficient for your needs, but it’s nice to have access to other, potentially lower cost investments as well.
If you have a large amount of appreciated company stock in your 401K, you need to consider net unrealized appreciation (NUA) and the special tax treatment from which you can potentially benefit. Consult your advisors if this situation applies-it is an extremely important, and often overlooked consideration.
It may be tempting to take a distribution of cash from your company 401K after separation, but BEWARE. This can be a costly mistake, resulting in taxes, penalties, and risk to your retirement cash flow. With the future of Social Security benefits uncertain, it is wise to use your retirement assets for their intended purpose- retirement.