The Bureau of Labor and Statistics reported in 2012 that U.S. workers have an average job tenure of 4.6 years, and will work for seven different employers during their lifetime. At least once or twice, many Americans will have to decide what to do with a 401(k) balance held with a previous employer.
If you switch jobs before retirement, these are the typical options for a 401(k):
- leave the money in your former employer’s plan
- transfer the money to your new employer’s plan (if the plan accepts transfers)
- transfer the money into an individual retirement account (IRA)
Because both 401(k)s and IRAs allow pre-tax contributions and tax-free accumulations, with distributions in retirement taxed as regular income, Americans may see the two plans as essentially the same. And many workers transfer old 401(k) balances to an IRA to preserve the tax status of their accumulations when they end an employer relationship. But for all their similarities, IRAs and 401(k)s also differ at several points.
Note: Besides 401(k)s, these provisions apply to all ERISA-qualified, employer-established defined contribution plans, which includes 403(b), 501(a), TSAs and others, including the federal TSP. For this article, the term 401(k) stands for all these plans.
The regulations governing a qualified retirement plan proscribe three distinct activities: contributing, accumulating and distributing. When deciding to keep a 401(k) with a former employer or transfer to an IRA, the key differences involve accumulation options and distribution choices, before and during retirement.
In a 401(k), the investment options are limited to those selected by an employer. These offerings may be quite diverse, but also may be changed by management. You have options, but the employer selects the menu. With IRAs, the investment choices are much broader, and the final say-so lies with the individual. For some, the opportunity to self-direct one’s retirement account is a major incentive to transfer a 401(k) balance to an IRA.
IRA assets can also be consolidated or divided according to individual preference. Consolidations may simplify organization and decrease management fees. But one can also hold an unlimited number of IRA accounts, which may be advantageous.
For example, one might use funds from one IRA to initiate a 72(t) distribution, while other accounts continue growing.
- 72(t) permits early distribution of funds without penalty as long as the withdrawals are in the form of a stream of substantially equal periodic payments consistent with IRS guidelines.) A 401(k) cannot be divided into two accounts with the same employer. Pre-Retirement Distributions 72(t): IRAs can be used for 72(t) distributions under any circumstance, at any time; 401(k)s really don’t allow 72(t) distributions. Per the IRS: “If 72(t) distributions are from a qualified plan, not an IRA, you must separate from service with the employer maintaining the plan before the payments begin for this exception to apply.”
- Loans: If the employer’s plan permits them, a portion of 401(k) balances can be accessed as loans. The maximum amount a plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less. With some exceptions, loans must be repaid on a regular schedule within five years. (If you terminate employment, unpaid balances are due immediately, or become taxable and subject to penalty.) IRA accounts do not have loan provisions.
- Early Partial Withdrawals: While IRAs have no loan provisions, there is no limit on early withdrawal amounts (although income tax and early-withdrawal penalties will apply); 401(k)s do not permit partial withdrawals, although unpaid loans end up with the same tax consequences.
Regular Retirement Distributions
- At 59½: For IRAs, the standard retirement age (the age at which funds can be withdrawn without penalty) is 59½. Some hardship provisions may exempt pre-59½ distributions from penalties.
- At 55: Under certain conditions, a 401(k) plan may allow penalty-free withdrawals if you leave your job at age 55 or later. (For some occupations, the penalty-free age is 50.) This provision applies only to a 401(k) balance with your last employer. If you have a 401(k) balance with a former employer and weren’t at least age 55 when you left, you must wait until age 59½ to take withdrawals from those accounts without penalty.
The age 55 provision could prompt early retirees to transfer previous 401(k)s to their current 401(k) plan (if the new plan allows it) before retiring from their current job. This makes all funds penalty-free after 55 but before 59½.
- RMDs: Once you reach age 70½, you must begin required minimum distributions from all IRAs. However, you don’t have to take required minimum distributions from a 401(k) as long as you are still working. RMDs from 401(k)s can be deferred until April 1 of the year after you retire.
Will a lot of American workers face a transfer decision about a 401(k) with a former employer? Probably. Will they know (or remember) these differences between transferring to another 401(k) or an IRA? Maybe, but probably not. There are a lot of details to keep track of.