It was the end of 2008. After a long time contemplating it, I finally pulled the trigger.

I gave my supervisor my resignation letter. It was past time to go elsewhere. It was probably the second-best professional move I ever made. The best one was what I did a couple of years later when my new employer decided to lay me off.

Then, realizing job security was a myth in today’s world, rather than look for another job, I started my own small business. That led to the success I’ve experienced for the past 12½ years.

As great as that journey was, I want to concentrate here on one aspect in common to both job changes.

In both cases, I had to decide what to do with my retirement plan balances. In the first case, it was a 403(b) plan, like a 401(k) for non-profits and certain government entities. In the second, it was an actual 401(k).

In both cases, I made the same choice. Before I spill the beans, let me first emphasize how important it is to prioritize your 401(k) whenever you transition jobs. 

“It’s important to keep your eyes on this most important retirement planning asset,” said  Yvonne Marsh, CFP, CPA, and Principal Advisor at Marsh Wealth Management.

“It’s easy to lose track of it if you leave it behind at your previous employer. For example, I just had a client send me a notice she received about a $116,000 401k she had left behind from a previous employer over 20 years ago – she had totally forgotten about it!”

What You Can Do with a 401(k) Balance When You Leave

If you’re quitting, like I did that first time, or suffering a layoff like my second time, you have either 3 or 4 options, depending on your account balance.

1. Leave the money where it is (assuming you meet the minimum required balance, typically $5000)
2. Roll the balance directly or indirectly into your new employer’s 401(k)
3. Roll the balance directly or indirectly into a new (or existing) IRA
4. Withdraw the balance

So, which should you choose?

There is no answer that’s right for everyone. As I like to say, personal finance is just that – personal. What’s right for me now may not be right for you and may even be wrong for me at a different time.

Below we’ll look at the pros and cons of each option.

But first, note that if your balance is under $1000, your old employer may simply make the choice for you, withholding 20% toward your possible tax liability and sending you a check for the rest. See below for more details of what that could mean.

If your balance is over $1000 but less than their threshold for allowing the money to stay in the plan (usually $5000), your old employer must give you at least 30 days’ notice about your right to withdraw the balance. If you fail to respond, they will most likely establish a rollover IRA for you.

Pros and Cons of Leaving the Money Where It Is

The Pros of Leaving the Money in the Old Plan?

• Simplicity (also known as “inertia”) – this doesn’t require you to do anything special.
• Your old plan’s investment options may be better than those available to you in your new employer’s plan or through an IRA – for example, it may give you access to unique investments such as institutional-class shares and/or funds closed to new investors.
• Your old plan’s fees may be lower than those in your new employer’s plan (however, they’re unlikely to be lower than an IRA invested in a “no-load” mutual fund).
• Your old plan may offer a free or low-fee advisory service that can help you make more informed investment decisions.
• If you’re 55 or older, and your old plan allows it, you may be able to start withdrawing money from the plan without penalty before you turn 59½ under the so-called “Rule of 55” – this can be a lifesaver if you were laid off and have no new income source (note that you’d still have to pay income tax on the withdrawals if the old plan was not a Roth 401(k)).
• Money in a 401(k) has better protections against lawsuits than does money in non-retirement plans or an IRA.

The Cons of Leaving It There?

• Another simplicity argument – leaving the money there requires you to track another account compared to rolling it over to your new employer’s plan (note that rolling it over into an IRA doesn’t reduce the number of accounts).
• You run the risk of forgetting the old account and losing all that money.
• Your old plan’s investment options may be more limited than those available to you in your new employer’s plan or through an IRA.
• Your old plan’s fees may be higher than those in your new employer’s plan and are almost certainly higher than those of an IRA invested in a “no-load” mutual fund.

As you can see, there are plenty of potential arguments for both sides. For some people, this may make the most sense, while for others, it would be less than optimal.

“When a person leaves their job, there are lots of reasons why they may want to leave their 401K where it is,” said Joe Dunat, Wealth Advisor at Sturkie Wealth Management.

“It has strong protection from creditors in cases of bankruptcy and lawsuits, and potentially one can even still take out a loan from the 401K, which is not available in IRAs.”

Pros and Cons of Rolling the Money into Your New Employer’s Plan

The Pros of Rolling the Money Over to the New Plan?

• If your balance doesn’t meet the old plan’s minimum requirement to stay (typically $5000), you can’t leave it in the old plan, so this is the only way to have that money benefit from the advantages of a 401(k)
• You don’t have to be concerned that you’ll lose track of the money if you leave it in the old plan, and you’ll gain the simplicity of tracking one less account
• Your new plan’s investment options may be better than those available to you in your old employer’s plan or through an IRA – for example, it may give you access to unique investments such as institutional-class shares and/or funds closed to new investors
• Your new plan’s fees may be lower than those in your new employer’s plan (however, these, too, are unlikely to be lower than an IRA invested in a “no-load” mutual fund)
• Your new plan may offer a free or low-fee advisory service that can help you make more informed investment decisions
• If you’re 55 or older, and your new plan allows it, if you leave employment before turning 59½, you may be able to start withdrawing money under the so-called “Rule of 55”
• Money in the new 401(k), just as in the old one, has better protection against lawsuits than money in non-retirement plans or IRAs
• If the new plan allows it, you’ll have access to 401(k) loans, where you borrow money from your account, and when you pay it back, the interest goes into the account

The Cons of Rolling Over Into the New Plan?

• Your new plan’s investment options may be more limited than those available to you in your old employer’s plan or through an IRA – for example, your old plan may give you access to unique investments such as institutional-class shares and/or funds closed to new investors
• Your new plan’s fees may be higher than those in your old employer’s plan (however, these, too, are unlikely to be lower than an IRA invested in a “no-load” mutual fund)
• Your new plan may not offer a free or low-fee advisory service that your old plan may offer

A Word on How You Do the Rollover

If you choose to roll the money over into the new plan, you’ll need to choose whether to do a direct rollover from the old plan to the new one or make an indirect rollover. In the latter case, you’d get a check from your old plan and will need to make a deposit into the new plan.

The latter is generally a bad idea.

The law requires your old employer to withhold 20% of your balance in case you owe taxes, and you won’t get that back (if at all) until you file your tax return the following year and get a refund.

Despite this, you’ll only have 60 days to deposit the full amount into the new plan, including that missing 20%. If you can’t come up with the extra cash, you’ll suffer three consequences:

1. You’ll owe taxes on the amount you can’t come up with
2. If you’re younger than 59½ (or 55 if you can use the Rule of 55), you’ll owe a 10% penalty on the missing amount
3. Your tax-deferred balance will forever be lower by the missing amount and its growth potential since you can only make it up before the 60-day window closes

If you have an urgent and temporary need for some money, explore other options such as a 401(k) loan from the new plan or any other plausible short-term solution. Use the indirect rollover only if there are literally no better options.

You should also consider if there are any other hidden rolling costs.

“Some plans are wrapped in annuities products, and those can be expensive to be able to roll out of,” said Erik Nero, CFP and Founder of First Stepwealth.

“If someone’s a little earlier in their savings career, it probably makes sense to remove those kinds of associated costs. These are typically seen with smaller company types of plans, as a lot of the insurance carriers are really in that end of the market, whereas it’s less prevalent among larger employers,” he said.

“So workers just need to take a look at the summary description document of their plan to see if there are any costs associated with rolling and weigh those in,” he added.

A Word on Another Possible Decision

Another decision you may need to make when doing a rollover is whether to choose a Roth option if your new employer’s plan has that available.

If your original plan was a Roth and the new plan has no Roth option, you’re almost definitely better off doing the rollover into an existing Roth IRA (see below). This is because it preserves the tax-free nature of your money, and if the IRA has been open for more than 5 years, you may be able to access all your contributions tax and penalty-free.

Note, however, that making even such a “free” withdrawal robs your future self of irreplaceable resources in retirement.

If your old plan wasn’t a Roth and the new one offers a Roth option, you may be able to convert your existing balance into a Roth. However, come tax time, you’ll need to pay taxes on the converted amount as if it was current income.

Pros and Cons of Rolling the Money into a New or Established IRA

What May Be the Pros of Rolling the Money Over to an IRA?

• You don’t like the old or new plan’s investment options better than what you can access in an IRA
• You don’t like the old plan and/or you’re concerned you’ll lose track of the money if you leave it in the old plan, and the new plan doesn’t accept rollovers (in this case, if you have multiple old 401(k) plans, you can roll them all into the same IRA or IRAs)
• Fees may be higher than a no-load IRAs in both your old and new 401(k) plans
• If your balance is high enough, you may be able to access free or low-fee investment advice from the manager of your rollover IRA

What May Be the Cons of Rolling the Money Over to an IRA?

• Money in an IRA isn’t as well-protected against lawsuits as money in a 401(k)
• Money in an IRA is never eligible for Rule-of-55 withdrawals

Again, if you choose this option, a direct rollover is almost always your best option.

If your old plan was a Roth, you can (and likely should) do the rollover into a Roth IRA to preserve its tax-free status. If you do this, it’s best to roll it over into an existing Roth IRA if you have one since the 5-year clock until you can withdraw your contributions tax and penalty-free has already been ticking for a while, potentially past the 5-year mark.

If your old plan wasn’t a Roth, you may still want to consider converting it by rolling over into a Roth IRA, especially if you expect your income to be lower than usual this year, especially if this places you in a lower tax bracket.

Pros and Cons of Simply Withdrawing the Money

Let’s Start with the Cons Because They’re Overwhelming

More than 8 in 10 young employees who leave their job simply cash out their old 401(k) balances, especially when the balances are relatively small.

In most cases, this is foolish in the extreme. Say you’re leaving your old job when you’re 25, and you have $2500 in your old plan. You’re starting a new job, and your total marginal tax rate is 30%. When you cash out the $2500, the plan will withhold 30%, 20% toward taxes, and 10% early-withdrawal penalty. At tax time, you’ll actually owe another ~10% because your marginal tax rate isn’t 20%, it’s 30%.

This means that out of the $2500, you end up with just $1500.

Further, if we assume a long-term average annual real (after inflation) return of 6% and that you’ll retire in 42 years at age 67, your $2500 would have grown to almost $29,000.

As you can see, you’d be grabbing $1500 now, but you’ll lose $29,000 (inflation-adjusted) when you’ll need the money to be able to retire.

Not a super-smart choice in most cases.

“The 401(k) is designed to be a long-term retirement savings vehicle, and that’s why Uncle Sam incentivizes you to use it with the gift of a tax deduction for your contributions,” said Marsh. “Take it out early, and you’ll lose a chunk of it to taxes and penalties. There are a few exceptions to the 10% penalty rules, but not many.”

Cases Where You Might Need to Do This Anyway and How to Minimize the Damage

If you absolutely must take the money to cover an emergency (think serious medical problems; extended loss of income; having your home destroyed, e.g., by fire or tornado; etc.), you can do so. In some cases, you may not owe the 10% penalty, and if the plan was a Roth 401(k), you won’t even owe taxes.

If this is your situation, here are your three steps:

1. First, explore all other options before cashing out your old 401(k)
2. Next, if you must cash out, minimize the damage by taking as little as you must
3. Finally, check if you qualify for an exception to the 10% early-withdrawal penalty (e.g., special circumstances related to military active duty, spousal and/or child  support, death, disability, medical expenses, you start making “Substantially Equal Periodic Payments” over your remaining lifetime, etc.)

A Note on Vesting

When I left employment, both times, I was fortunate enough that my employers’ plans were set up such that all employer contributions were vested immediately.

This is not true in all, or even in most cases.

Most employers follow either a gradual vesting schedule, where employer contributions become yours in steps over time or a deferred “cliff” vesting, where it becomes yours all at once after a certain length of employment.

Talk with your old employer’s Human Resources Department to find out the details in your case so you aren’t blindsided when you get significantly less out of your old 401(k) plan than what your most recent statement showed.

What Happens if You Took Out a 401(k) Loan from Your Old Plan?

It used to be that if you had an outstanding balance on a 401(k) loan and left employment, you had very little time to pay it all back, or the remaining balance would become a de-facto early withdrawal, with all the negative consequences mentioned above.

Following the 2017 “Tax Cuts and Jobs Act,” if you took out a 401(k) loan from your old plan and are leaving employment for any reason before paying it all back, you can continue making payments to a rollover IRA.

This new tax law gives you until your tax filing deadline (including all extensions) to finish paying back the loan in full before considering the unpaid balance an early withdrawal, subject to all the consequences of such a withdrawal.

The Bottom Line

Having a balance in an old employer’s 401(k) plan is, obviously, better than not having it. If it does exist, you need to choose whether to keep it there (subject to a minimum balance requirement), roll it over into your new employer’s 401(k) plan or an IRA, or potentially cash out that balance. In the above, you can see the pros and cons of each option, as well as some other relevant details.

Given how significant the consequences may be, you should contact your accountant and/or financial planner to make the most well-informed decision you can. And now, I’ll finally share what I did in both cases. I did a direct rollover into traditional IRAs. Since then, the money in these rollover accounts has grown 4-fold. Not too bad, huh?

Now it’s up to you to save and invest according to what’s right for you.

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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.