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Retirement Planning > Saving for Retirement > 401(k) Plans

Your Client Left Their Job. What Should They Do With Their 401(k)?

By Roger Wohlner

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What You Need to Know

  • Choosing the right 401(k) exit strategy for clients leaving a job is an important part of their retirement planning.
  • Factors such as their age and taxes must be considered.
  • Each client’s situation is different, and your planning for their old 401(k) should reflect their needs. 

Your clients may leave a job for a variety of reasons. The job market conditions of the past couple of years have caused many employees to switch employers in search of higher pay and other perks. It could be due to retirement or an involuntary situation.

Whatever the reason, when your clients leave a job, it’s important that they have a 401(k) exit strategy laid out. Here are some things to consider in order to help guide them to the best strategy for them. 

Rolling Over to an IRA

Rolling the client’s 401(k) balance over to an IRA is often the best option. This allows them to consolidate not only the money from this 401(k) but also from other 401(k)s from former employers all in one spot. 

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If the client has some of their 401(k) money in a designated Roth account, this portion can be rolled over to a Roth IRA. This offers the advantage of not having to take required minimum distributions on this money when they reach age 72. 

Rolling their 401(k) to an IRA offers a number of advantages: 

  • An IRA will offer a wider range of investment choices than a 401(k) plan. Assuming you are managing the client’s investments, this strategy allows you to incorporate this money into the strategy you have in place for the client’s other investment assets.
  • Investing via an IRA is often a lower-cost alternative for your client, especially if their former employer’s plan was a high-cost plan. 
  • People will work for a number of employers over the course of their career. Consolidating old 401(k)s and other retirement plan accounts in one place helps to ensure that retirement assets in old employer plans will not fall off the radar.

1 One disadvantage of rolling the money over to an IRA is that IRAs do not offer creditor protection as does a 401(k) plan. This is something to consider if this is a factor based on your client’s situation. 

Net Unrealized Appreciation (NUA)

If your client decides to roll their 401(k) balance to an IRA upon leaving their job, they can take advantage of the net unrealized appreciation rules if their 401(k) account contains shares of their former employer’s stock. 

Under the NUA election offered by the IRS, if your client owns company stock inside their old employer’s 401(k), they can elect to take a distribution of the shares. These shares would go into a taxable account. They must then pay ordinary income taxes on the cost basis of the shares. 

The advantage is that if the shares are held for at least a year after the distribution, they will be subject to preferential long-term capital gains rates if sold at a gain from the original cost basis. In the case of shares that are highly appreciated, the tax savings can be significant. There is, of course, the risk that the share price could drop over time as well. 

If the client had other assets in their 401(k) such as mutual funds, this money would be rolled over to an IRA as normal. 

Leaving the Money in the Employer’s Plan

This might be a viable option in some cases for certain clients. It can make sense if the plan options offered in the plan are rock-solid and low-cost, especially if you would have trouble putting the client in investments that are as good or better than the ones in the plan by rolling the money over. 

Another consideration is whether your client needs the added level of creditor protection offered by a 401(k) plan. It’s important, however, to note that some employers may treat the accounts of former employees differently from those of current employees. Be sure your client does their homework on this before deciding to go this route. 

Rolling Over to a New Employer’s Plan

If your client is changing jobs and moving to another employer, it can make sense to roll their 401(k) balance over to the new employer’s 401(k) plan if that employer accepts rollovers. As with any investment decision, it’s important for you to review the new employer’s plan to ensure that it offers a solid, low-cost investing menu for your client. 

Beyond this, there may be other reasons to consider rolling their 401(k) balance over to a new employer: 

  • If creditor protection is an issue for your client, the new employer’s plan will offer this as opposed to the limited protection that may be available in an IRA.
  •  If your client is considering a Roth IRA conversion, including a backdoor Roth, now or in the future, to the extent their 401(k) is in a traditional account, this eliminates adding more to their traditional IRA balance. This will lessen the impact of the pro rata rule on future conversions, saving taxes in the process.
  • If your client is 72 or nearing that age and plans to continue working, moving this balance to their new employer’s 401(k) will allow them to defer taking required minimum distributions on this money if the new employer has made the appropriate elections to their plan documents.

These benefits can also apply to a reverse rollover from a traditional IRA to your client’s 401(k) plan with their current employer if that plan accepts these types of rollovers. Though not a direct rollover from a 401(k) plan, a reverse rollover from a traditional IRA into a 401(k) plan can be a viable strategy for some clients. 

A reverse rollover might be done in conjunction with rolling over money from a client’s old 401(k) to a new employer, or on a stand-alone basis if it fits your client’s overall financial plan. 

A reverse rollover can consist only of IRA funds that were originally contributed to the IRA or a prior 401(k) plan on a pretax basis. Funds contributed on an after-tax basis are not eligible. 

Withdrawing Some or All of the Money in the Plan

Generally, this is not the preferred option for your client, as there can be taxes and penalties involved. Your client, however, may need or want to take some or all of these plan assets for current use. 

One option is the rule of 55. In this case, if your client leaves their employer during the calendar year they reach age 55 or later, they can withdraw the money in their 401(k) penalty-free, but not tax-free. This can be a solid way for your client to fund an early retirement or use the money for other purposes. 

If your client is at least 59½, they might consider withdrawing some of the money if needed to fund early retirement needs and then roll the rest over to an IRA. In the case of a traditional 401(k) the money will be taxed, but there will be no penalties. If they will be in a lower-than-normal tax bracket in the year they are leaving their employer, this can be a solid strategy as they enter retirement. 

If they have a Roth 401(k) and they are 59½, any withdrawals will be tax-free as long as they have met all other criteria for a qualified distribution. Again, this can be a good strategy to fund early retirement needs or other needs they may have. In the case of a partial withdrawal, they can roll the rest of the Roth money over to a Roth IRA. 

Another option if your client wants to withdraw all or a certain amount of their old employer’s 401(k) prior to age 59½ is to use the series of substantially equal periodic payments, or SOSEPP, method. Under this option, they can take a series of distributions and pay taxes only on the amount distributed each year instead of a larger amount in a single year when leaving their employer. 

A SOSEPP could be done via rolling the money to an IRA and then taking the payments from the IRA. This could conceivably be done by leaving the money in the old employer’s plan and then taking the withdrawals from there, but you will want to have your client make sure their old employer’s plan will allow this.

There are strict rules on SOSEPPs, and they must be followed in order to avoid triggering unwanted taxes and penalties. These rules include that the SOSEPP must continue until they reach age 59½ and must last for at least five years regardless of age. 

Conclusion

Clients leaving their job, voluntarily or otherwise, need your help in determining the best course of action for their 401(k) plan with their old employer. The best 401(k) exit strategy will vary by client and may involve a combination of tactics. Your guidance is invaluable to your clients in making the most of these important retirement assets. 

 Roger Wohlner is a financial writer with over 20 years of industry experience as a financial advisor. 

Roger Wohlner

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