Planning for retirement is smart! And a 401(k) plan is probably the easiest way to do it.
But what happens when you quit your job? Or pass away?
401(k) plans were designed to encourage and help Americans prepare for retirement. They are funded by money deducted from your salary and set aside for when you retire.
Since 401(k) accounts are attached to employment, there is often some confusion around what happens when you quit your current job or pass away. The most common questions tend to be:
- Does it roll over to the new job? How?
- When you die, who gets it?
- What if you have no will?
Let's explore all the technicalities of what happens to your 401(k) when you switch jobs or pass away.
What happens to your 401(k) when you quit your job?
There are different options to explore when you quit your job. You may leave your 401(k) account as it is with your old employer, transfer to an individual retirement account (IRA) or roll it over to the new employer's plan. Some people even use this opportunity to cash out some or all of it.
Each option has important factors to think about before deciding.
1. Leave your 401(k) with your former employer
Your former employer may let you leave your 401(k) plan as-is if you have $5,000 or more invested. You can choose to do nothing if you like the old plan and have a good amount invested. However, if you could get a better plan with more investment opportunities and lesser fees, you should consider other options—like rolling it over to your new employer.
Things to note:
- With this option, you can no longer make contributions to the 401(k) of the old job. This makes it harder to monitor the different plans you leave with various former employers; some people forget about old accounts.😬 Try to keep track of the statements and paperwork related to the old account.
- Most employers match their employees' 401(k) contributions. If you leave your 401(k) as-is, the employer matching will stop as well.
- If your contribution in the former plan is less than $5k, your old employer can only hold on to it for 60 days. After this period, your former boss may force you out of the plan by creating an IRA in your name, depositing the funds, or cashing it and sending you a check.
- If your former plan included employer matching, you only own the amount you contributed. Your previous employer's contributions to your account are subject to a vesting schedule. If you quit before the matched contributions are fully vested, you forfeit them completely.
- If your old employer goes out of business, your funds will still be intact. However, tracking down the required officials to sign off on a transfer or payout may be a paperwork nightmare you don’t want. Be sure to keep your old employer updated with your current address and phone number to avoid this.
- If you cannot contact your old employer, you can track your old 401(k) plan on different unclaimed assets platforms like the National Registry of Unclaimed Retirement Benefits, the Dept. of Labor Abandoned Plans, or FreeErisa. You may need to use your social security number to access information on these databases.
- If you change your mind about leaving your 401(k) with your old employer, you can reach out to the company with instructions on whether to distribute your funds or transfer to an IRA.
Smart tip💡: Sign up for your new employer's 401(k) plan immediately after you start. In about six months, you should understand the new plan better and be able to compare the investment options and costs with your old 401(k) plan and decide if it's smart to roll it over or do nothing.
2. Transfer your 401(k) to an IRA
If your new job doesn't offer a 401(k) plan or you don’t plan to get another job soon, you can transfer your old 401(k) to a rollover IRA—a new retirement account that’s not tied to employment. The best part about this option is that you get to choose the financial institution you want and are no longer limited to the choices of your old employer. You also get more investment choices, lower fees, and full account control.
Things to note:
- You can convert your 401(k) plan to a Roth IRA account and get tax-free withdrawals.
- IRAs can include various assets (like stocks, mutual funds, bonds, and even annuities). If you have some company stock in your former 401(k), note that it may be liquidated when you rollover to an IRA and taxed as normal income.
- If you had a Roth 401(k) with your old employer, rolling over to a Roth IRA is tax-free. The same applies to rollovers from a traditional 401(k) to a traditional IRA.
- It's best to find a brokerage or Robo-advisor with a lot of experience with rollovers. The options are endless!
- You must pay off any outstanding loans plus interest from your existing 401(k) within the stipulated time frame before you rollover. If you don't, the loan amount is considered a distribution for tax purposes.
- If you hold a Roth retirement account for at least five years and are more than 59½ years old, you can get distributions without having to pay taxes.
- Your old employer should electronically transfer your 401(k) balance directly to the IRA administrator to avoid tax implications. If the funds are transferred directly to you, your old employer will withhold 20% as income tax.
Smart tip💡: If you find yourself in financial need, it’s possible to borrow from your own 401(k). But a 401(k) loan can be risky! If you cannot repay in time, the IRS will treat the entire loan as a taxable withdrawal with steep tax consequences. Instead of a 401(k) loan, opt for personal finance in the form of friend and family loans. The repayment terms are more flexible, and your retirement savings are left intact. Pigeon makes it easy to get fast and easy, friends and family loans in a well-defined process where all parties are legally protected.
3. Rollover to your new employer's plan
If your current employer offers a 401(k) plan that allows rollovers and you're eligible, great! Rolling over your old account should be easy. However, some employers make new employees put in some work days before being allowed to participate in the retirement plan.
Once the account with the new company is set up, ensure it's active and ready to accept contributions before you start the rollover process. Once set, your former employer will make a tax-free direct rollover transfer of the balance of your old account to the new one.
Things to look out for:
- If the investment options and fees of the new plan are not encouraging, rolling over may not be the best idea.
- The benefits of this option are similar to that of keeping your old 401(k) plan. However, with this new plan, you can make more investments and get employer matches for as long as you remain on the job.
- Your contributions to the new plan are not subject to the required minimum distribution policy even when you are 72 years old.
- Rollovers from one qualified retirement plan to another (employer-offered 401(k) to another) are tax-free.
Smart tip💡: Try to get your old employer to distribute the funds in your old account by writing a check in the name of your new 401(k) account administrator. Know that you must deposit the funds in your new account within 60 days to avoid income tax and a 10% early withdrawal penalty if you are under 59½ years old. As stated earlier, your old employer will have to withhold 20% of the funds for federal income tax if the check is made to you.
4. Cash out your 401(k)
Nothing stops you from taking a lump-sum distribution of your old 401(k), but many financial advisors warn against it. Not only will you drastically reduce your retirement savings, but there is a tax burden: you will have to pay ordinary income tax on the entire withdrawal. You may also have to pay the 10% early withdrawal fee. If you are laid off and need to access the funds for emergency purposes, try to take what you need and transfer the remaining to an IRA.
Smart tip💡: Instead of cashing out your old 401(k) in a financial emergency, you could get a loan from your friends and family via Pigeon so that you don’t have undergo penalities. These loans are faster to access than withdrawing form your 401(k), and if you really need to, you can create an agreement with your loved ones that ties the value of the loan you want to some future value in your 401(k) - seek out advice from a legal or financial professional before executing this idea. 😉
What happens to your 401(k) when you die?
You must decide what will happen to your 401(k) when your time is up. These conversations are not the easiest, but they are essential in ensuring your savings are distributed according to your wishes.
Most retirement plans are based on a typical life expectancy; it’s important to plan for that and even beyond. But unfortunate things can happen. You should also be aware of what will happen to your money if you were to pass away earlier than expected.
With 401(k)s, various scenarios could come into play if you die before retirement. Ideally, your savings will go to the designated beneficiary or beneficiaries of the account. If there's no will and you named no beneficiaries to the account, the savings will be directed to your estate.
Let's assess these scenarios in detail.
1. When you have designated beneficiaries
When you join a retirement plan at work or via an IRA, you add a beneficiary to the account by filling out a beneficiary form. This individual(s) can be anyone—usually a spouse, sibling, friend, or other loved one—and they will have control over the account when you pass away. You can change beneficiaries at any time and also have the option not to add a beneficiary.
- Primary Beneficiary: Legally married surviving spouses are usually the primary 401(k) beneficiaries. They are protected by many federal laws and can remain beneficiaries of the said account even after a divorce if it wasn't changed in the decree. They also automatically inherit your savings when you die, except if you made someone else (or multiple others) your beneficiary designation(s). In this case, your legal spouse must sign a waiver before the non-spouse beneficiaries can access the inherited IRA and its payout.
- Someone else: as stated earlier, you can add anyone as your primary beneficiary, from your siblings to kids and even a charity organization. You don't need anyone's consent to do this if you're single. However, if you're married, you need your spouse's consent to add other people, even the kids you share, to your list of beneficiaries.
- Contingent Beneficiary: this is a backup individual that receives your funds if your primary beneficiary or spouse dies before you do or doesn't want to be your beneficiary.
If you have multiple retirement savings accounts, you must assign beneficiaries to each to avoid any problems.
Note⭐️: Your 401(k) beneficiaries can override the instructions you make in your will. Suppose you chose a beneficiary in your 401(k) account and named another individual to inherit your account in your will. In that case, the designated 401(k) beneficiary overrides the instructions in your will.
2. When you don't assign beneficiaries
Unfortunately, untimely deaths can happen before 401(k) account holders assign beneficiaries. Here, the savings go to the deceased's estate. They will be subject to estate tax and shared according to the instructions in the will, if there is one.
If there is no will, after the account owner’s death the savings will be distributed between the deceased's heirs following the laws of intestate succession, which often goes from spouse to children then parents, siblings, etc. The funds will go through probate court, which can be a strenuous experience for the grieving family, and the money may not be distributed as you would have wanted.
How your 401(k) is distributed to beneficiaries
The funds in your 401(k) will be distributed to the named beneficiaries following the conditions of the plan. For traditional 401(k) plans, the funds grow tax-deferred and are then subjected to income tax rates upon distribution to your beneficiaries. For Roth IRA plans, the beneficiaries get tax-free distributions.
The beneficiaries must submit the death certificate to the associated financial institution. If all documents check out, they can access the funds.
Here's how the funds may be distributed:
- Required minimum distributions: if you want to support your 401(k) beneficiaries for a long time, an RMD is what you need. Your beneficiary can choose to receive minimum equal distributions annually as you did for a period without penalty.
- Rollover distributions: if the plan administrator wants the entire 401(k) distributed when the original account holder dies, the beneficiary can rollover the funds into a new or old inheritance account. This rollover will not be taxed, but subsequent withdrawals will be.
- Lump-sum distributions: many 401(k) plans let beneficiaries cash out the plan in one transaction. The total amount will be subject to income tax if it's a traditional 401(k), but there won’t be any early withdrawal penalties.
Important update🚨: According to the 2019 SECURE Act, 401(k) beneficiaries must withdraw all the funds within ten years from the original account holder's death. This Act overrides the RMD caveat and sets no minimum distribution amount as long as all the funds are withdrawn in ten years or fewer. If the beneficiaries fail to withdraw all the funds within ten years, they may have to pay a 50% excise tax on the remaining amount according to the IRS.
This bill was passed to ensure Americans don't outlive their retirements and to create more tax income for the government. However, there are some exceptions.
The SECURE Act doesn't apply if you are:
- the surviving spouse of the deceased,
- chronically ill or disabled, or
- less than ten years younger than the deceased.
If a minor child is the named beneficiary, the SECURE Act comes into play when the child turns 18.
Interesting fact🤔: Some beneficiaries choose to leave the account in the deceased's name. This is not common, but it is often done to delay the required action on the account. However, the beneficiary would legally have to start withdrawing the minimum distributions within the year the deceased would have turned 72.
401k plans help people secure their futures financially. However, like every other adult financial move, getting the most out of your 401(k) requires proper estate planning and wealth management to avoid issues. Knowing what happens to your 401(k) when you quit a job or die will help you make the best timely decisions to protect your future, and it all starts now!
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