‍Since 2021, HR professionals have been dealing with high employee turnover rates and resignations as people started to return to work following the start of the COVID-19 pandemic. The “Great Resignation” shows no sign of stopping. More than 50 million workers quit their jobs in 2022 compared to around 48 million in 2021, according to federal data.  With a minimum of 5.43% and a max of 16.9%, the average employee turnover rate across all industries for 2022 is 9.31%.  So what does all this mean?

Millions of Americans are switching jobs each year and with 69% of private industry employees having access to an employer-provided retirement plan according to data released by the U.S. Bureau of Labor Statistics in 2022, understanding options for your 401(k) funds is crucial.  The following will discuss you options for your 401(k) funds when you separate from a job. These options include the rollover, distribution, leaving the funds where they are, or inaction.

The Rollover

Generally, in order for a 401(k) plan participant to do a direct or indirect rollover, you generally need to satisfy a plan triggering event. The most common triggers are:

• Over the age of 59 1/2
• Leave your job
• Plan is terminated

Direct rollovers to another retirement plan are tax free; there will be no withholding tax if you perform a direct rollover. However, once every 12 months, you have the opportunity to do an indirect rollover, which gives you access to those funds for 60 days. Any taxable, indirect rollover distribution paid to you and not transferred directly to another retirement account is subject to a mandatory income tax withholding of 20%. The withholding tax would apply even if you intend to roll it over later to another retirement plan. If you do roll it over and want to defer tax on the entire taxable portion, you’ll have to add funds from other sources equal to the amount withheld. Certain distributions from a 401(k) plan are not eligible for a rollover, such as a required minimum distribution or a hardship distribution.

The most common direct rollover option for an employee that leaves his or her employer with a 401(k) plan is a rollover to an IRA. There are close to $500 billion dollars of 401(k) rollovers a year. The primary reason the direct IRA rollover is the most popular option for employees leaving a job with a 401(k) plan is because of investment options. There are far more opportunities with an IRA than a 401(k) plan, including individual stocks, real estate, cryptos, precious metals, private business investments, investment funds, and much more. This is because you are the trustee of your IRA; in the case of a 401(k) plan, the company is responsible for plan investments and bears some fiduciary risk which is why 401(k) plan investment options tend to be on the conservative end.

Tips to Consider before Performing a 401(k) Rollover

• A direct rollover is the answer if you are leaving your job, even if you want to pull money out of the plan. Roll the funds directly into an IRA and then take a distribution, without a 20% withholding tax.  If under the age of 59 1/2, tax and a 10% early distribution penalty would be due, but not payable until April 15 of the next year which gives you more use of the funds without tax.
• If you do an indirect rollover, remember you can only do once every 12 months and must return the funds within 60 days to an IRA or another 401(k) plan. In addition, you will likely be subject to the withholding tax.

Taxable Distribution

When leaving your job, you always have the opportunity to take a taxable distribution of the funds.  However, remember that in the case of a pretax 401(k) plan, a distribution prior to the age of 59 1/2 will trigger ordinary income of the amount distributed plus a 10% early distribution penalty.  Once over that age, just taxes would be due. If you have a Roth 401(k), contributions can be distributed tax-and penalty-free, although the earnings would be subject to tax and penalties if applicable. In addition, a 20% withholding tax would apply to the amount taken as a taxable distribution.

Leave Funds in Former Employer Plan

Most employer plans will allow an employee that has separated from the company to keep his or her funds in the company 401(k) plan. This is not the most popular option since 401(k) plan investment options are limited. In addition, fees on 401(k) plan investments are typically higher than those of IRAs.  Notwithstanding, some plans do not allow former employees to keep their existing 401(k) funds in the company 401(k) plan due to the administrative costs and liability risks.  This is especially true for account balances below $5,000.

Ideally, you should cut all ties with your former employer. There are reasons why you no longer work there, why leave anything behind? In rare cases, the plan might actually be really good, with decent investment options and low fees. Generally, this is not the case – get out as soon as possible!

Inaction (The Safe Harbor IRA)

When a former employer is unable or unwilling to maintain a small residual balance for a former employee, or if the plan itself is terminating, and they are unable to contact a plan participant, or do not receive a response from an attempt to contact, they can send these funds to a third-party IRA custodian to establish a mandatory-rollover, or “Safe Harbor IRA.” This is a specific IRA established when a 401(k) plan elects  to force out their small-balance participants with less than $5,000 of 401(k) funds, after they’ve separated employment. Former employees with greater than that amount are not subject to these rules and their can stay in plan. Not all 401(k) plans have Safe Harbor force-out provisions in their plan documents. It’s important to note that SECURE Act 2 will increase the $5,000 threshold to $7,000 beginning on January 1, 2024.

The impact of the Safe Harbor IRA rules are significant! From 2004 through 2013, workers leaving their jobs also left behind at least 16 million retirement accounts with balances of $5,000 or less, according to the U.S. Government Accountability Office. That money belongs to retirees, but such small balances can easily be devoured by fees or lost track of by their owners.

Conclusion

As this article detailed, an employee with a 401(k) plan that has a separation of employment has several options with respect to the 401(k) funds in the former employer plan. The most common choice is the direct rollover to an IRA option – it is tax-free and can provide the plan participant with greater investment options and control over the funds. Fees related to IRA investments are typically lower than with a 401(k) plan, plus the IRA distribution and hardship rules are more flexible than a 401(k) plan.

The other options are far less appealing. If you absolutely need the money, take a distribution, just be aware of the tax consequences and penalties. Whatever you do, don’t forget about that money – you earned it, it’s yours! Of course, we feel your best course of action is to take control of your retirement with a Self-Directed IRA, which gives you the freedom to invest in what you want, when you want.