According to the U.S. Department of Labor, the average person will change careers 5-7 times during their working life. Approximately 30% of the total workforce will change jobs every 12 months. In addition, a Fast Company’-Harris Poll from found that approximately half 52% of American employees are considering making a career change this year. 44% are already planning to make the switch. Moreover, according to the U.S. Bureau of Labor, 69% of private industry workers had access to employer-provided retirement plans in March 2022. 52% of private industry workers chose to participate in a retirement plan. despite the large quantity of small (fewer than 100 employees) DC plans, which consist of 84% (584,864) of the total DC plan number, these small plans contain only 13% (12.7 million) of the total participants and 13% ($1.0 trillion) of the total assets. Therefore, if you are one of the millions of Americans who switched jobs over the last year or are contemplating switching jobs and have access to a 401(k), 403(b), or 457(b) plan, you will want to continue reading this article
Defined Contribution Triggering Event
In general, unknown to many Americans, you don’t have unfettered access to your 401(k) funds. You need a reason to take the funds out of your 401(k), which is called a “triggering event.” A lot of people don’t realize a triggering event is a must to touch the funds within your 401(k). After all, the money belongs to you, as should the decision of what to do with it, right? But this is how the government incentivizes all of us to save for retirement.
There are three ways that you can take your funds out of your 401(k) plan:
- Be over age 59 ½ (retirement age)
- The company terminates the 401(k) plan
- You leave your job (or you are let go)
Options for Taking Funds from a Former Employer-Defined Contribution Plan
If you have a 401(k) from a former employer or thinking about leaving your job and have a 401(k) plan, the following are the most popular options you will have concerning your employer-held retirement funds.
- Tax-Free IRA Rollover
The most common direct rollover option for an employer who leaves their job with a 401(k) plan is a rollover to an IRA. There are close to 500 billion dollars of 401(k) rollovers a year. A direct rollover from a 401(k) to an IRA is tax-free. 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 investment 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.
- Tax-Free Self-Directed IRA Rollover
Just like an IRA rollover, an individual who has funds in a former employer 401(k) plan has the option of doing a tax-free rollover to a self-directed IRA. A self-directed IRA is essentially an IRA that allows for alternative asset investments, such as real estate or even cryptocurrency. Traditional financial institutions do not allow IRAs to invest in IRS-approved alternative assets, such as real estate, because their focus is on earning fees through traditional investments. Hence, if you want to invest your IRA funds into alternative asset investments, such as real estate, the self-directed IRA is your best option.
A rollover from a former employer 401(k) to a Self-directed IRA is viewed as providing a greater degree of investment diversification. Additionally, since almost all 401(k) plan fund investments are directed into publicly traded securities, gaining the advantage of doing a tax-free rollover to a Self-Directed IRA is an increasingly popular option.
Tips to consider before doing a 401(k) rollover:
- Even if you want to pull money out of the plan, roll the funds directly into an IRA and then you can take a distribution without a 20% withholding tax. If under the age of 591/2, 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 it 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 a 20% withholding tax.
- Taxable Distribution from the Former Employer 401(k) Plan
If you are leaving your job and have a 401(k) plan, you always can take a taxable distribution of the funds. Although, in most cases, a 20% withholding tax would apply to the amount taken as a taxable distribution. In addition, it is important to 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 and the amount distributed plus a 10% early distribution penalty. Whereas, if over the age of 59 1/2, then just tax on the amount distributed. In the case of a Roth 401(k), all Roth 401(k) contributions can be distributed tax-free and penalty-free, although the earnings on the Roth 401(k) contributions would be subject to tax and a 10% penalty if the plan participant is under the age of 59 1/2 and just income tax if over the age of 59 1/2 at the time of the distribution. In addition, a 20% withholding tax would apply to the amount taken as a taxable distribution.
- Leave Funds in Former Employer Plan
Depending on your employer 401(k) plan, most employer plans will allow an employee who has separated from the company to keep their funds in the company 401(k) plan. This is not the most popular option since 401(k) plan investment options are far more limited than IRAs. In addition, fees on 401(k) plan investments are typically higher than those of IRAs. Notwithstanding, some 401(k) plans do not allow former employees to keep their existing 401(k) funds in the company 401(k) plan due to administrative costs and liability risks. This is especially true for IRAs below $5,000.
- Tax-Free Rollover to a Solo 401(k) Plan
Just like a rollover to an IRA, if one is self-employed or has a small business with no full-time employees other than the owners or their spouses, one can rollover former employer 401(k) funds to a Solo 401(k) plan.
A Solo 401(k) plan is not a new type of retirement plan. It is a traditional 401(k) plan covering only one employee. A Solo 401K plan is perfect for any sole proprietor, consultant, or independent contractor.
The following are the major advantages of establishing a Solo 401(k) in 2024:
High Contribution Limits: With a Solo 401(k) Plan, a plan participant of a Solo 401(k) Plan can make annual contributions of up to $69,000 annually with an additional $7,500 catch-up contribution for those over age 50 in 2024.
Loan Feature: With the Solo 401k Plan, a plan participant is eligible to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose, including paying credit card bills, mortgage payments, personal or business investments, a car, vacation, or anything else. The loan has to be paid back over a five-year period at least quarterly at a minimum prime interest rate (you have the option of selecting a higher interest rate).
“Checkbook Control”: One of the most popular features of the solo 401k Plan is that it does not require the participant to hire a bank or trust company to serve as trustee. This flexibility allows the plan participant (you) to serve in the trustee role. This means that all assets of the 401(k) trust are under the sole authority of the Solo 401k participant. A Solo 401(k) plan allows you to eliminate the expense and delays associated with an IRA custodian, enabling you to act quickly when the right investment opportunity presents itself. Making a Solo 401(k) Plan investment is as simple as writing a check.
Mega Roth: Contribute up to $69,000 or $76,500 all in Roth with the “mega backdoor” Roth option. Keep the funds in Roth in the plan or even rollover the Roth funds to a Roth IRA tax-free.
Secret Weapon for Real Estate Investors: Under Internal Revenue Code Section 514, a Solo 401(k) is not subject to the unrelated business taxable income tax (UBTI or UBIT) on the use of a non-recourse loan (leverage) in connection with the purchase of real estate. Whereas, an IRA that uses leverage to purchase real estate would be subject to the UBTI on the debt-financed portion of the property. The current maximum UBTI tax rate is 37%.
Conclusion
There are many good reasons for leaving a job. The saying “everything happens for a reason” is a popular phrase and it appropriately applies to many instances when people leave their job or retire. If you have left a job or planning to leave a job and have an employer 401(k) plan, hopefully, this article was helpful in providing you with available options for the former employer 401(k) funds. Overall, a rollover to an IRA or a self-directed IRA is the most popular tax-free option.
