Changing Jobs and 401(k) Rollovers

Chances are very high that you will not be employed with the same employer for your entire life. This brings up the question of what happens to your 401(k) account with a particular employer when you change jobs.

There are two general answers to this question: The money in your 401(k) account stays in your account or the money is taken out of your account. Depending on your plan's provisions, you may be able to keep the money in your former employer's 401(k) plan.

Tip As a general rule, you should never leave your money sitting in your former employer's plan. Employer plans may offer limited investment options. By investing in an outside retirement savings account, like an IRA, your investment choices can be limitless.

If a participant in a qualified retirement plan like a 401(k) has an account balance of $5,000 or less upon separation, the employer may distribute any nonforfeitable or vested account balance without the participant's consent to save on its administrative costs. Money that you contribute to the plan is always nonforfeitable, but employer contributions may require a certain period of employment before becoming available or vested. Plans that make involuntary distributions and have $1,000 to $5,000 in the account automatically transfer the account balance directly to a designated IRA, unless a participant affirmatively elects to have the distribution transferred elsewhere.

Under these requirements, mandatory distributions from a retirement plan, including governmental and church plans, must be paid in a direct rollover to an individual retirement plan unless the distributee elects to have the amount rolled over to another retirement plan or to receive the distribution directly. A mandatory distribution is a distribution that is made without the participant's consent and is made to a participant before the participant attains the later of age 62 or normal retirement age. However, a distribution to a surviving spouse or alternate payee does not count as a mandatory distribution.

The plan administrator must notify a distributee in writing when a distribution will be paid in a direct rollover to an IRA. In the meantime, contact your plan administrator if you have any questions about the mechanics of the automatic rollover provision.

Some people who leave an employer simply cash out their 401(k) plan prematurely. This is a big mistake and should be avoided if humanly possible. In addition to losing the time it took to save that money, the money is taxed and a penalty of 10 percent is imposed on the taxable portion of the distribution. Instead, the best route you can take is to make a tax-free rollover.

Rollovers. Although the term may sound like a trick to teach a pet, a rollover of a retirement plan involves transferring money from one qualified plan to another. To qualify as a tax-free rollover, a distribution must be rolled over within 60 days after the money is received. A 401(k) plan may be directly rolled over to another defined contribution plan that accepts direct rollovers, an individual retirement account, an individual retirement annuity, or a qualified annuity plan.

Warning If you are rolling your 401(k) money into an IRA, make sure it is separate from any other IRA plan you may have. You will then retain the ability to later roll over the separate IRA to another employer's 401(k) plan. This may be desirable, for example, when the employer's plan allows participants to borrow money from their accounts.

The money can also be distributed to the account holder directly. The person receiving the distribution then has 60 days to deposit the money to a qualified plan or Keogh plan that accepts rollovers, an individual retirement account or annuity, or a qualified annuity.

Warning This is a very important point, so please pay close attention. If an employee does not elect a direct transfer and decides instead to receive it directly, the distribution is subject to a 20 percent withholding rate. The employer takes out the money before the distribution is made. Also, tax is withheld even though the distribution is ultimately rolled over within 60 days and is considered a nontaxable distribution. Those that don't know about this fact get an unpleasant surprise when they receive the distributions from their 401(k). They get an even bigger shock when they learn that they must roll over the entire amount from their former 401(k) plan, including the 20 percent that was taken out for withholding tax, to avoid having to pay the taxes and penalties associated with making an early distribution from a retirement plan. For example, if a 401(k) plan account had $100,000 before distribution, $20,000 would be withheld from that amount. To qualify for a tax-free rollover, you would then have 60 days to somehow come up with $20,000 and deposit it as required together with the $80,000 received from the distribution. If you do manage to make up the shortfall, it is some consolation that you will probably get a big refund check when you file your tax return because you overpaid your taxes. However, why let Uncle Sam use your money for free while you get yourself in debt, lose income you could have earned on that money or pay unnecessary taxes and penalties? Instead, make sure any rollover you make is a direct rollover.

The IRS is authorized to waive the 60-day rollover period if the failure to grant such a waiver would be "against equity or good conscience, including casualty, disaster, or other events beyond the control of the individual subject to such requirement." This doesn't give you the green light to be late with your rollover. It does, however, provide significant relief from the 60-day requirement in cases where you are prevented from making valid rollovers through no fault of your own (e.g., bank error, hospitalization, postal error, death, incarceration).

If an employee is married and leaves the employer the hard way by dying, the surviving spouse of the deceased 401(k) or other qualified retirement plan participant is entitled to make a tax-free rollover of the money distributed from the deceased's account. The tax-free rollover can be made to an individual retirement account, to another qualified plan, to a 403(b) annuity, or to a 457 governmental plan that the surviving spouse participates in. Keep in mind, though, that the rules allow, but do not require, such plans to accept rollovers.

Example David Mulder participated in his employer's 401(k) plan until his death in February of 2013. His surviving spouse, Scully, participates in a 457 governmental plan. After Mulder's death, Scully is entitled to make a tax-free rollover of the distribution from her deceased husband's 401(k) to an IRA or to the 457 plan maintained by her employer, who allows rollovers to be made.