Malky Kleinberg had planned for many things when she’d left her job behind, but one item she’d ignored was her 401(k) account. The company she’d left had offered a plan with a generous match, which Mrs. Kleinberg had taken advantage of. But she’d never understood all the fine print, and now she was concerned. 

Could her former place of employment take her savings? 

How could she gain control over the money?

Don’t panic

Employees who leave 401(k) accounts behind don’t need to panic. 401(k) plans are protected by legal barriers including independent custodians and fidelity bonds, so loss through thievery or confiscation is very rare. And these protections extend to current and former employees. While Malky will obviously not get any more contributions from her ex-boss, her savings should be secure for the time being. Any investments she made will continue growing, and the company is obligated to inform her of any plan changes or fee adjustments. Not all companies follow every letter of the law, but the funds are generally quite safe.

Doing Nothing

Many employees leave their 401(k) benefits with former employers for years, even decades. Most such accounts will continue functioning, unattended but largely unmolested. Typically, leaving your accumulated savings behind isn’t the end of the world, but it isn’t ideal either. An exception to this would be if the 401(k) has some kind of unique investment offering (a possible pro) or will charge excessive fees (a possible con). Also, smaller sums (under $5,000) just sitting in a former employee’s 401(k) may be “forced out” into an IRA in the employee’s name or into a check mailed to the employee’s home.

Taking It Out in Cash

When an employee leaves a company with a 401(k) account, they’re supposed to get a written notice explaining their options in great detail. One of these options is simply to take out in cash whatever the employee has accumulated (and “vested”, which is another conversation). Should the employee so select (via a form), the custodian holding onto the 401(k) account will sell any remaining investments and send them a check.

It’s often tempting to just grab the money, but for several reasons, this path is often a bad idea. First, money cashed out of a non-Roth 401(k) plan is taxable income which can diminish expected health insurance subsidies and other social assistance. Worse, withdrawals from retirement accounts made prior to age 59.5 are hit with an additional 10% tax penalty. To top it off, the 401(k) custodian handling the cash-out will withhold and forward to the IRS 20% of the account balance (plus state withholdings) toward these tax obligations. This withholding may be refunded at a later date, but the process adds salt to the financial wound. Finally, money removed from retirement accounts diminish the potential for future tax sheltering.

Rollover to a New IRA

The best course of action when leaving a company with a 401(k) balance is usually to roll it over into an IRA. This avoids any taxes and penalties while leaving the funds sheltered as they grow further. IRA accounts can be tapped penalty free for excessive medical costs or higher education expenses (including a child’s accredited seminary or beis midrash costs).

While it’s possible to do this rollover yourself after receiving a 401(k) balance in cash, it’s easy to mess up the procedure—and if you mess up, you’ll be taxed and probably penalized. Therefore, the preferred solution for a rollover is arranging a trustee-to-trustee transfer.

The process is simple. First, open a Rollover IRA account with any brokerage company (Fidelity, Vanguard, etc.). Typically, there is no fee. Then, using a form provided by your employer, instruct the 401(k) custodian to send your 401(k) balance directly to the new IRA. Voilà!

The one clarification that needs to be made is whether investments held in the 401(k) can be transferred to the IRA as is; in some cases they need to be sold first, after which the resultant cash can be deposited into the IRA. It’s generally not a big deal either way.

An Added Nuance

This is a bit in the financial weeds for some folks, but many 401(k) plans allow for Roth contributions. Any such funds should go into a corresponding Rollover Roth IRA so the employee can enjoy its offer of permanent tax-free growth. Also, if the terminated employee will end up working for another employer who offers 401(k) plans, they may be able to do a trustee-to-trustee transfer into the new plan (either directly from the previous 401[k] to the new 401[k] or from a Rollover IRA to the new 401[k]). Of course, this maneuver is only helpful if the new plan accepts rollovers and if there’s a specific benefit motivating the use of this feature.

The Loan Conundrum

One final point Mrs. Kleinberg may need to deal with is the fact that outstanding retirement plan loans usually become due immediately when an employee leaves their place of employment. Money borrowed from a 401(k) account is owed only to yourself, but from a tax perspective, these funds belong back in the retirement account. Should a loan from a terminated 401(k) not be paid back by tax time (or replaced into an IRA), the loan “offset” is treated as a withdrawal. As noted, such withdrawals are fully taxed, plus there is a 10% penalty for those under age 59.5. Repaying the loan is clearly preferable but may prove difficult for someone leaving a job. A conundrum.

Where’s the Guidance?

I get a lot of questions about 401(k) basics, things that should be evident to those who were given even introductory guidance. Clearly, many employees are being offered 401(k) plans but without any assistance in using them effectively. This is a pity because retirement plan benefits can be extremely powerful and flexible when properly utilized. How ironic is it that many only learn all the details of their 401(k) plans on their way out of them?

Either way, no dollar should be left behind.