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3 times when leaving your 401(k) with a former employer may be smart

Shelly  Gigante

Posted on December 22, 2022

Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
When not to rollover your 401(k)
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This article will...

Outline your options for your 401(k) after you leave your job. 

Describe how leaving your 401(k) with a former employer may give you more flexibility.

Explain some of the downsides to leaving your 401(k) behind, which may include higher fees and lower returns. 

Many retirement savers take their 401(k) with them when they leave their job, often rolling the balance over to an IRA — a move that simplifies the planning process and potentially allows for greater control.

But there are certain instances when leaving your 401(k) with a former employer might be the better move. For example, if you:

Before deciding what action to take with your retirement savings, it's important to understand your choices and the implications of each. A financial professional can help you determine which path forward is best for you.

Understanding your options

When you part ways with an employer, you have three options (in some cases, four) for your 401(k). You can:

Roll it over to an IRA. The biggest benefit here is control. IRAs typically offer a more robust menu of investment options, including fixed-income securities for those nearing retirement, so you can better customize your portfolio allocation. Note that if you roll over to a Roth IRA, you will owe income tax on the entire account balance today, but the earnings will grow tax-free and are not subject to required minimum distributions during retirement, which would potentially enable your account to continue delivering tax-free growth for longer. Be aware that if your former 401(k) includes company stock and you roll it over to an IRA, there could be tax penalties involved. In such cases, it is important to consult a tax professional for advice.

Roll it over to your new employer’s 401(k), if permitted. Some employers allow new hires to roll assets from a prior 401(k) into their plan. If you like the investment options available at your new job, that can make future financial planning easier. It’s just less paperwork. (Learn more: What to do with an old retirement account)

Cash it out. This is ill-advised in all but the direst of financial circumstances. Not only will you undercut your ability to retire comfortably and on time, but you will owe ordinary income tax on your account balance (because your contributions and earnings were never taxed), plus a 10 percent early withdrawal penalty if you are younger than age 59½.

Leave it behind. Lastly, you may be able to leave your 401(k) with your former employer if the plan permits. (Note that those with  balances of less than $5,000 may be forced to roll their balance over to an IRA if they wish to keep their retirement savings invested in a tax-deferred account, as employers are not required to maintain smaller accounts—it costs them money—and are legally permitted to cash them out.)

Here's a closer look at the specific circumstances for which leaving your 401(k) behind might be ideal.

Better investment options and fees

Leaving your 401(k) with a former employer may be wise if the investment choices are better or the fees they charge are less.

This is sometimes the case when you move from a large employer to a smaller one, as bigger companies often have the asset size to negotiate lower portfolio management fees.

“In addition to possibly having good investment options, your former employer’s 401(k) may give you access to institutionally priced investments,” said Greg Hammond, chief executive officer of Hammond Iles Wealth Advisors in Wethersfield, Connecticut. “Institutional share class investments in an IRA may require large minimum investment amounts or charge higher transaction fees to purchase them.”

You may need early access to your retirement savings

If you leave your job in or after the year you turn 55 and you anticipate that you may need to withdraw savings from your retirement account before age 59½, your money is best left in your 401(k) account. Or, at least, some of your money.

Why? The rule of 55.

“If you retire or are let go from your current employer during or after the calendar year you turn 55, you can take withdrawals from your 401(k) without incurring the 10 percent early withdrawal penalty,” said Hammond, noting that you would still owe ordinary income tax on the amount withdrawn. “Most investors are aware of the 59½ age requirement for penalty-free IRA withdrawals but are not aware of the earlier age of 55 that is available with a 401(k).”

By rolling over your account balance to an IRA, he said, you would lose that flexibility.

Note that financial professionals typically advise against withdrawing money from your retirement savings early unless your guaranteed sources of income and personal savings are sufficient to sustain your standard of living throughout retirement.

Access to a stable value fund

Those nearing retirement who wish to maintain a more conservative asset allocation may also wish to keep their 401(k) where it is.

The reason: Most 401(k)s offer stable value funds, which seek to preserve principal primarily through a combination of fixed-income securities and insurance-company contracts.

“These insurance-wrapped bond funds that maintain a stable share price, while usually offering a competitive yield, are not available outside of 401(k)s,” said Hammond.

In some cases, he said, retirement savers will keep the fixed-income portion of their portfolio in the 401(k) stable value fund and do a partial rollover to invest the equity portion of their retirement portfolio outside the 401(k).

The downside of leaving your 401(k) behind

As you determine next steps for your 401(k), consider that there are potential downsides to leaving your money behind, too.

For starters, you will not be able to make new contributions to the plan once you leave your job. That could potentially compromise your compounded growth as the account will only ever deliver returns based on the account balance as of your last day of work. (You can and should continue to make contributions to your new employer’s 401(k) or your IRA.)

You may also be charged higher annual maintenance fees as a former employee.

And you will lose the ability to borrow from your 401(k) after you part ways with your boss. IRAs do not permit loans either, of course. But many employers allow current employees take loans of up to 50 percent of their 401(k) account balance, up to a maximum of $50,000. Such loans must typically be repaid with interest (that goes back to you) within five years. (Learn more: Borrowing from your 401(k): The risks)

“The number one downside to leaving your 401(k) with a former company is the inability to borrow from your 401(k) plan,” said Paul Tokarz, a financial professional with WestPoint Capital in Chicago, who noted that there are some employer-sponsored 401(k) plans that do not allow loans. “That being said, most of the time the ability to roll over to an IRA gives the client freedom of investment choice, professional advisory custom rotation in the portfolio, and even the ability to hold real estate in a self-directed IRA.”

The good news is that there is no pressure to decide how to manage your 401(k) when you leave for greener pastures. There is no time limit. You can leave your 401(k) behind at first while you consider your options and roll it over at any point in the future.

As with all things financial planning, the best choice is an informed one. And many consult a financial professional to understand the choices.

Discover more from MassMutual…

4 reasons why maxing out your 401(k) may not be enough

How a 401(k), Roth combo may help young savers

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The information provided is not written or intended as specific tax or legal advice. MassMutual and its subsidiaries, employees, and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.Opinions expressed by those interviewed are their own and do not necessarily represent the views of MassMutual.