- Roll over your 401k when changing jobs to keep retirement savings growing.
- Avoid an early withdrawal penalty through loans, hardship withdrawals, or an involved strategy called SEPP.
- Let your money grow in your 401k as long as possible to enjoy a happy retirement, but know that you must make required withdrawals at age 70 1/2 or face IRS penalties.
You’ve been in the workforce for a few years now. You’ve got a decent amount of professional experience, and — hopefully — a decent chunk of change saved in your company’s 401k account. You’re more or less on track to meet you retirement goals until suddenly, something changes.
Maybe you decide to change jobs to continue your professional growth. Or maybe you run into some hefty and unexpected expenses. In either case, you might think about withdrawing the money from your 401k — either to move it to your new employer’s account or to cover unforeseen bills.
No matter the reason, be careful. Your 401k is a retirement account with tax benefits, and as a result, it has some specific withdrawal rules imposed by the IRS.
What Are the 401K Withdrawal Rules If I Switch Jobs?
If you’re changing jobs, congratulations! You’re moving to bigger and better things. But don’t forget about your old company’s 401k. There are generally three options available:
- Keep the money in your old company’s 401k
- Move the money to an IRA
- Rollover your current 401k into your new company’s 401k plan
1. Keep the money in your old company’s 401k
While you may move on, your 401k savings can often stay with your previous employer. If you have an amount saved of over $5,000, you can usually let it grow tax-free in its original account until you retire although this might not be the best option.
2. Move the 401k savings to an IRA
On the other hand, if it’s less than $5,000, your old company will usually write you a check (which will have tax consequences) or allow you to move the 401k savings to an Individual Retirement Account. In either case, you’ll want to contact your original employer’s Human Resources to determine how best to continue saving for retirement while avoiding penalties.
3. Rollover 401k savings
No matter how much you have saved, if you move to a new employer that has its own 401k plan, you will likely be able to rollover the savings from your old account into your new one. First, ask your new company’s human resources department how to get started.
Since people change jobs more frequently now, it’s usually best to rollover your 401k. Otherwise, you might flat out forget about a decent chunk of change that you’ve left with a former employer.
In general, the best way to complete a 401k withdrawal — whether you’re putting that money into an IRA or 401k — is completing a direct transfer from your old 401k provider to the new retirement plan administrator rather than receiving a check at home.
For instance, meet Ben, who is leaving his current job. He talks to his current HR manager about the best way to transfer his $25,000 from his 401k account with his current plan administrator (Vanguard) to his new account with Fidelity. However, after analyzing the fee structure for Fidelity’s 401k offerings, Ben decides he’d rather put his retirement savings into an Independent Retirement Account (IRA) with much lower management fees.
He therefore opens a Roth IRA at Charles Schwab to receive his Roth 401k contributions and a traditional IRA to receive his employer’s match contributions. His representative at Charles Schwab instructs Vanguard to transfer the funds into Ben’s two new IRAs. As a result, Ben never touches the money and is safely exempt from income tax withholding and penalties because the two brokerage firms handled the transfer directly.
If you decide to move the money to either an IRA or your new 401k account yourself, you’ll likely be subject to income tax withholding, and you’ll have to complete the transfer within 60 days of the initial withdrawal to avoid paying a penalty. If you wait longer than 60 days, you will face penalties and will have to pay income taxes on the amount withdrawn.
Early 401k Withdrawal Penalties
In recent decades, Americans have been given more and more responsibility for their own retirement. While companies would previously provide employees with a pension plan funded by contributions taken directly from their paychecks, employees must now opt in to contribute to their 401k plan. Americans must now preserve those savings over the course of an entire career.
To help individuals build nest eggs and deter workers from dipping into their retirement funds before they reach retirement age, the IRS has placed guard rails around those 401k withdrawals. The primary guard rail comes in the form of early withdrawal penalties, such as an additional 10% tax penalty on any amount you take out before you turn 59 1/2.
It’s easiest — and much more lucrative — to wait until you reach the appropriate age to withdraw from your 401k. Not only will you avoid paying additional tax, but your money will have more time to grow tax-deferred. And after all, 401ks were designed to be used once you’re at a retirement age.
401k Withdrawal Rules That Avoid a Penalty
While it’s best to wait until retirement age to touch your retirement savings, there are a few circumstances that would allow you to withdraw from your 401k account without paying the 10% tax penalty. For instance, if you separate from service or leave your job at 55 years old (50 years old if you work in the government), you can collect from your 401k without penalty.
There are an additional three scenarios that might allow you to withdraw your 401k funds early and without penalty:
- 401k loans
- Hardship withdrawals
- Substantially Equal Periodic Payments (SEPP)
One way to take out an early withdrawal without paying a penalty is through a 401k loan. Just keep in mind that you can only avoid the 10% penalty if you repay the loan with interest — although that interest will go into your 401k account and not to a bank.
Just as with any other loan, a 401k loan will require you to pay back the principal amount within a specified time frame — usually five years — with interest. However, in comparison to other private loans, interest rates are usually relatively low, which is why many individuals choose to a 401k loan over other types of loans. In addition to IRS rules, your 401k plan administrator will have its own policies you’ll have to note. If you leave your job, the loan balance becomes due immediately or otherwise it’s considered a withdrawal and subject to taxes.
While you might be tempted to take out everything you have in your 401k account, the IRS limits how much you can withdraw — again in an effort to keep U.S. residents on the right trajectory for retirement. As such, the maximum amount you can loan yourself is either 50% of your vested account balance, or $50,000 — whichever is less. That said, if 50% of your account balance is less than $10,000, you may borrow up to the full $10,000 — if your plan allows it.
You can use the funds for just about any reason, although some plans might only allow loans for specific purposes, so it’s a good idea to read the fine print in your plan documents. In general, the IRS provides some guidance for how a 401k loan might be used, including things like funding a down payment on a house, paying unexpected medical expenses, or helping with education expenses. If you’re married, your spouse’s consent might be required.
Now, while a 401k loan might be a low-interest way to give yourself a quick cash infusion, there will be consequences for your retirement savings.
First of all, some loans won’t allow you to make contributions while you have a loan outstanding. So, if you have a five year loan repayment period, that’s five years of lost tax-advantaged growth for your money.
Second, if that is the case and your employer provides an employer match, you will also miss out on that free money for the length of the loan.
Finally, the money you’ve borrowed won’t be able to reap the investment returns it could have gained if it had stayed in your account.
While a hardship distribution is similar to a 401k loan, the primary difference is that a hardship distribution does not need to be repaid — although you still need to pay the appropriate amount of income tax on any withdrawal.
Not all employers allow for hardship distributions, and those that do must conform to some very strict IRS stipulations. First, in order to qualify for a hardship distribution in the first place, the funds must be used for:
- Unexpected medical expenses
- Costs relating to the purchase of a home
- Tuition and related educational fees and expenses
- Payments necessary to prevent foreclosure on or eviction from your home
- Burial or funeral expenses
- Expenses for the repair of damage to your home
- Up to 12 months’ worth of tuition and fees
Next, your employer may require proof that you have no other funds available to meet your needs. Additionally, the withdrawal must be enough to address your expense and no more.
If all that sounds good, take note — there are additional requirements you must meet if you want to avoid paying the 10% penalty on the withdrawal. In order to avoid the penalty, the IRS has a laundry list of very specific requirements of which you must meet at least one.
For instance, you can avoid the penalty if the account owner is totally and permanently disabled. Or if you need to pay medical debt that exceeds 10% of your adjusted income, or you have been issued a court order that requires you to give the money to a divorced spouse, child, or other dependent.
Not only is it difficult to meet the requirements to avoid a 10% penalty, but similar to a 401k loan, taking a 401k hardship distribution can severely hurt your chances of saving enough for retirement. You’ll have less money in a tax-advantaged account where it could grow, and you’ll also have to pay income tax on any amount you withdraw at your current tax rate. That rate could be significantly higher than if you had waited until you were eligible to withdraw the funds penalty-free after age 59 1/2 and stop working.
Substantially Equal Periodic Payments
A Substantially Equal Periodic Payment (SEPP) is a periodic payment plan that allows individuals to withdraw funds from a 401k retirement account prior to the age of 59 1/2 while avoiding the 10% penalty. However, again, there are several stipulations in order to qualify and important and somewhat complex steps to follow.
First of all, this type of payment plan is only allowed if you no longer work for the company that holds the 401k account you would like to withdraw from. Second, as the name suggests, the withdrawal takes place annually over a long period of time with a minimum plan of five years. As such, this is not a good option if you’re looking for a quick, lump-sum distribution, as in the case of 401k loans or a hardship distribution.
Additionally, you cannot cancel the plan before the minimum holding period expires. Otherwise, you will have to pay the IRS interest and all the penalties that were waived on any amount withdrawn under the program. The IRS allows several different methods to determine how to distribute your retirement funds, with each based on a life expectancy or mortality table. If this method of withdrawals is your only option to withdraw from your 401k, be sure to consult a tax adviser to structure your SEPP properly.
How to Manage Required 401k Withdrawals
Even if you somehow manage to navigate your way to retirement without the need to roll over your 401k when you move to a new employer or take early withdrawals, you will — eventually — have to withdraw the money.
When you reach the age of 70 1/2, the IRS requires you to take what is known as a Required Minimum Distribution (RMD), whether you need the money or not, so that the government can start collecting income taxes. If you’ve stored your retirement funds in a Roth 401k, you won’t have to pay income taxes on the RMD but you are required to make these distributions when you reach 70 1/2. If you’re still working and your employer’s 401k plan allows it, you may not have to take the RMD at all.
The good news is you will not have to pay an additional 10% penalty for these withdrawals. And if you’re already retired, your income may have decreased — along with your tax bracket. As such, even though you are required to pay taxes on RMDs, the tax bill could be at a much lower rate than if you had withdrawn the funds while still working.
Save for your 401k Responsibly and Retire Worry-Free
Saving for retirement should be a high priority financial goal, no matter your age or income level. A critical step in any personal finance journey is taking full advantage of the different tax-advantaged retirement accounts available.
However, if one day you find yourself in a position where you need to withdraw funds from your 401k account, remember to be careful. Managing your 401ks from different employers and being aware of the consequences of early withdrawal is key to ensuring that money continues to grow.
You probably won’t need to worry about withdrawals for a long time. Until that time, continue to save responsibly for a worry-free retirement that allows you to spend your days however you see fit — whether that’s relaxing at home, traveling the globe, or spending time with family and friends.