Four Options for Old 401(k) Plans

Receiving statements in the mail from “old 401(k)s” can be a nuisance. Even worse is losing track of those accounts. If either case applies to you, it may be a symptom that your personal finances are not in good order.

Unlike group health insurance benefits, when you leave an employer, you can take your 401(k) account with you. The money in that account is yours, and you are responsible for managing it. You control what happens to that money, and it pays to manage it well.

You have four options in deciding what to do with your old account:

  • Leave it in the former employer’s 401(k) plan
  • Roll it over to the new employer’s 401(k) plan
  • Roll it over to an individual retirement account (IRA)
  • Take a distribution

Each option has pros and cons, depending on your circumstances.

Leave Your 401(k) Account Where It Is

This is the default option. If you don’t take action, your funds will stay in your former employer’s 401(k) plan.

The primary benefit of this option is that it requires no effort. Your money will remain in your account, invested in the investment choices you selected.

Another potential benefit is that you may have access to professional investment management of your money through professionally designed model portfolios in your account’s list of investment options. If you don’t work with a qualified financial advisor or otherwise have access to professional investment management advice, this could be an important consideration in deciding whether to leave your money in a prior employer’s 401(k) plan.

Plan sponsors incur costs in operating 401(k)s, and often those costs are passed on to participants as higher expense ratios on investment choices or fees charged directly to accounts. Employers decide how much of the cost of operating their 401(k) plan they pay and how much they pass on. If your former employer passes on most of the cost of operating the plan, then the mutual fund expense ratios or account fees in that plan may be high. You may find it worthwhile to consider other options for your account.

Another potential downside is that you may simply lose track of the account and fail to pay proper attention to it. If you’ve lost track of a 401(k) account, call your former employer to get your statement delivery restarted or get online access to your account. Even though you are no longer contributing to the account, you need to review the investments at least once a year and preferably two to three times per year. The 401(k) plan sponsor (your former employer) may change investment options in the account during the year, either removing existing options you might be using or adding new options that may be better.

You also should review your account to determine if it has drifted from your target mix of investments. For example, if you selected a U.S. large company stock index mutual fund for 20% of your account balance and it appreciated 20% during the year, you should change its allocation from 24% back to the 20% you originally selected. This process is called rebalancing, and you should consider rebalancing your account at least once per year. Rebalancing needs to happen regularly, and it may not if you’ve lost track of your accounts.

There is a common exception to this default “leave your money where it is” option for small account balances. Many 401(k) plans have a provision that says that if the participant’s balance in the plan is less than a certain amount (for example, $5,000), then the plan sponsor may force a distribution or create a rollover IRA and move the funds to that new account. If you have a small account balance, leaving your funds in your prior employer’s 401(k) plan may not be an option.

Rollover to New Employer’s 401(k) Plan

The second option for your old account is to roll it over to your new employer’s 401(k) plan. A rollover is the process of transferring the balance by carefully following the IRS rules that allow the money in your accounts to maintain tax-deferred status and not inadvertently triggering income tax and early withdrawal penalties on the amount transferred.

Rolling over old accounts to your new employer’s 401(k) plan is an effective way to consolidate accounts and keep all of your employer retirement plan money in one place. However, not all plans accept rollover transfers from other 401(k) plans. Confirm with your new employer that their plan accepts rollovers before using this option.

Having all of your employer retirement plan money in one place makes management easier. You will need to regularly review only one set of investment options and their performance. You will need to create only one investment allocation, which involves selecting the amounts you will invest in each of the available investment options as a percentage of the total account balance. And you will need to rebalance only one account to its target investment allocation one or more times per year.

Reasons you may not want to consolidate accounts relate mostly to the quality of the new plan compared with the old plan. High-quality 401(k) plans offer a robust list of investment choices, allowing you to create a portfolio diversified across the major asset classes at low total cost to you. High-quality plans may also give you access to investment advice through professionally designed model portfolios. If your old 401(k) plan is of higher quality than your current employer’s plan, you might consider not rolling over your old 401(k)s. If your new employer’s plan is of higher quality, then rolling over old accounts to consolidate them in your new employer’s 401(k) plan could be a good option.

Rollover to an IRA

A popular option for old 401(k) accounts is a rollover to an IRA. As with rollovers to a new employer 401(k) plan, IRA rollovers involve transferring your old 401(k) account balance by carefully following IRS rules to maintain the tax-deferred status of the amount transferred. An IRA can be used to collect and consolidate all of your old 401(k) accounts.

One main advantage of rolling over an old 401(k) to an IRA is the many more investment choices available, particularly for IRAs held at investment brokerage firms such as Fidelity, Charles Schwab or TD Ameritrade. In an IRA, you can choose from individual stocks, bonds, mutual funds, exchanged-traded funds (ETFs) and others—most of the tradeable securities available on U.S. exchanges—and you are not limited to the 20 to 40 investment choices, typically mutual funds, commonly found in 401(k) plans. However, the greater number of investment options may not be helpful if you are not prepared to make your own investment decisions and are not working with a qualified financial advisor.

The cost of managing your investments in an IRA can often be much less than the costs that your investments will bear in an employer-sponsored 401(k) plan. The costs also are much more under your control. For example, you decide when to buy and sell securities in your IRA, and you directly control the transaction costs you incur.

There is an important limitation of IRAs in protection from creditors. Unlike 401(k) accounts, which are protected from creditors under the Employee Retirement Income Security Act (ERISA) of 1974, IRAs may be afforded only partial protection depending on the state in which you live. In California, for example, IRA assets are protected from creditors only up to the amount needed for your support in retirement considering all of your resources likely to be available as determined by the court.

If you work in an occupation that puts you at higher risk of being sued, the creditor protection of a 401(k) account may be an important consideration in deciding whether to roll over your 401(k) to an IRA. For example, physicians face a substantial risk of being sued, exposing their assets to creditors with a judgment against them. A recent California Court of Appeal decision held that IRAs consisting 100% of funds rolled from employer 401(k) accounts would receive full creditor protection.[1]However, mixed 401(k) rollover contributions and regular IRA contributions in a single IRA account was not addressed, leaving uncertainty regarding this common situation. If asset protection is a concern for you, consider consulting with a qualified attorney.

Take a Distribution

A fourth option for your old 401(k) account is to take a distribution. A distribution is a withdrawal of funds from your account. The distribution is taxable income to you in the year of the distribution (assuming your contributions were pre-tax). This income is taxed at your ordinary income tax rates. Usually, if you are younger than 59 ½, you will also pay a 10% early withdrawal penalty.

Generally, distributions should be carefully planned and taken only in your retirement years, when you will likely be in a lower income tax bracket than during your working years. Taking a distribution of your entire account balance before retirement is recommended only in the most desperate circumstances. The distribution is added to your income for the year, potentially pushing you into a high tax bracket, which, combined with the early withdrawal penalty, can cause more than one-half of the distribution being used to pay tax. For example, if 39.6% federal and 9.3% California income tax rates apply to the distribution amount, and adding the 10% early withdrawal penalty, you would be paying 58.9% of your distribution amount toward income tax. The actual tax cost is even greater if you include the effects of lost income-tax deductions phased out at high income levels.

If you must take an early distribution, there are two methods for avoiding the early withdrawal penalty that you may be able to take advantage of. The exceptions are listed in Internal Revenue Code Section 72(t)(2) and included here:

Age 55 Rule: The first exception allows that if you separate from service with your employer (i.e., terminate employment for any reason) during the calendar year that you turn age 55 or later, the 10% early withdrawal penalty will not apply.[2] The exception is sometimes called the “Age 55 Rule.” The rule applies only to funds in your current-employer plan and not to funds from prior-employer plans.

You must still wait until age 59 ½ to take distributions from prior-employer 401(k) plans without incurring the early withdrawal penalty. However, if you roll old 401(k) accounts into your current-employer 401(k) plan before you retire or otherwise terminate from your current employment, the rule would apply. If you plan to use the Age 55 Rule, consider rolling your old 401(k) accounts into your current 401(k) beforehand.

Please be aware that this rule does not apply to IRA accounts. Leaving your money in your employer-sponsored 401(k) plan allows you to access your money 4 ½ years earlier than an IRA without incurring the early withdrawal penalty. If you are between the ages of 55 and 59 1/2, consider leaving your money in your 401(k) plan and not rolling over to an IRA until age 59 ½ to take distributions without incurring the 10% early withdrawal penalty.

Substantially equal periodic payments (SEPPs): The second exception allows anyone participating in a 401(k) plan to take distributions beginning at any age without incurring the early withdrawal penalty if the distributions are part of a series of “substantially equal periodic payments” over their life expectancy.[3] The exception is commonly called “Rule 72(t).” The distributions must be taken at least annually. They must also begin after separation from service (i.e., termination of employment for any reason).[4] Once you begin taking distributions, you must continue them for at least five years or until you reach age 59 ½, whichever is longer. More information about the rules and calculation of distribution amounts can be found at the IRS website:

Make sure you’re aware of the options for your old 401(k) plan accounts and evaluate them periodically.

[1] McMullen v. Haycock, 54 Cal. Rptr. 3d 660 (Cal. Ct. App. 2007).

[2] Internal Revenue Code (IRC) Section 72(t)(2)(A)(v).

[3] IRC §72(t)(2)(A)(iv).

[4] IRC §72(t)(3)(B).