What to do with 401k when laid off?

If you have been laid off or let go unexpectedly, it is likely that you had not prepared for what lies ahead. As you figure out your next move, you should decide what to do with the 401(k) money left with the former employer. Confronted with the reality of a long job search ahead, some employees opt to cash out their 401(k) accounts. However, cashing out could be an expensive option due to the taxes you will owe. Instead, you should consider other alternative options for your retirement savings that don’t dip into your retirement money.

Once you’ve left your job after a layoff, you can decide to leave the 401(k) in the former employer’s plan, rollover to a new employer’s 401(k), rollover to an IRA, or take a distribution. Rolling over to an IRA is a more convenient option since it does not trigger taxes, and you get access to a wider selection of investment options. This gives you investment flexibility, since you can choose investments that suit your needs, and with the lowest fees.

What Happens to a 401(k) When You Are Laid Off?

Once you are let go by your employer, there are certain changes you should expect with the 401(k) plan. They include:

Contributions stop

When you leave your job, you lose access to the employer's 401(k) plan, and you can no longer contribute to the retirement plan. Also, if your employer provides a match, you will no longer receive the additional contributions to your retirement account. However, you still own the vested balance in your 401(k) account.

Lose unvested money

Depending on the vesting schedule provided by your employer, you could lose part of your employer’s contributions that have not yet vested. If the employer’s contributions become fully vested in three years, and you are laid off in the second year when you are 50% vested, it means you will lose the other 50% unvested portion of the employer’s contributions.

You incur admin fees

As an employee, the employer covers fees associated with managing the 401(k) plan. Once you leave the job, the employer will no longer cover these 401(k) fees, and you may be required to shoulder the cost of managing the retirement savings. If the returns fall below the fees charged to manage the 401(k) account, the fees could eat into your retirement savings.

You can no longer take 401(k) loans

Once you leave the employer, you can no longer borrow a 401(k) loan against your retirement savings, since there is no assurance you will pay. Usually, 401(k) loan payments are deducted automatically from your paycheck, and the paychecks stop when you leave. Therefore, if you were to get a 401(k) loan as a former employee, you will be solely responsible for making loan payments. This increases the risk of default.

What to do with 401(k) When You Are Laid Off

If you are caught up in downsizing and you are yet to get another job, you should decide what to do with your retirement savings. Here is what to do with your 401(k) money:

Leave the 401(k) with Your Former Employer

If you are comfortable with the investment options provided in the former employer’s plan, you can decide to leave the 401(k) money in the former employer’s plan. You must have a 401(k) balance of over $5,000 to leave your retirement savings in the 401(k) plan. The retirement money will continue growing tax-deferred, and you will continue receiving periodic reports on the performance of your investments. However, you will no longer contribute to the 401(k) account.

If you are not comfortable with some of the available investment options provided by the employer, or the 401(k) fees are too high, you could consider your other options.

Rollover to new 401(k)

If you have moved on to a new job, and you like the investment options of your new employer, you can consider rolling over the old 401(k) into the new employer's 401(k) account. However, before you initiate the rollover, you should check with your new employer to know when you are eligible to join the company’s 401(k) plan. Some employers may require employees to work for a specific number of months before they are eligible to join the company’s 401(k) plan.

Once you join the new 401(k) plan, you can request a direct rollover of the 401(k) funds to the new 401(k) account. You will be required to fill some paperwork to complete the transfer. This transfer is known as a direct rollover, and it does not trigger taxes. An alternative option is to ask the plan administrator to send you a check with your 401(k) money. You must deposit the check in the 401(k) within 60 days.

Rollover to an IRA

If you are looking for investment flexibility, rolling over 401(k) to an IRA is the most viable option. You can choose this option if your new employer does not have a retirement plan, or if you don’t like the new 401(k)’s offerings. An IRA gives you a wide pool of investment options to choose from, and you will no longer be restricted to the investment options pre-selected by your employer.

Start by opening an IRA account with a bank or brokerage firm. You can then ask the old 401(k)'s plan administrator to rollover your 401(k) funds into the IRA. A direct trustee-to-trustee transfer is completed within a few days, and it does not trigger taxes. If the plan sponsor sends you a check, you should deposit it into the IRA account to avoid triggering taxes.

Cash out

Taking money out of your retirement plan for personal use is often advised against since it denies your money tax-deferred growth in addition to the tax implications it will have. When you cash out, you could lose about 30% of your distribution to taxes and penalties. Usually, when the plan sponsor sends you a check, it will withhold 20% of the distribution for tax payment. If you are below 59 ½, you will be required to pay an additional 10% early withdrawal penalty. Also, cashing out could jeopardize your retirement goals, and you could miss out on years of compounded retirement savings growth.