When Cashing Out an Old 401(k) Makes Sense

Key Takeaways

• For some reason in 2023 and early 2024, there has been a wave of layoffs. And once you’re laid off, you have an old 401(k). Now you have options. Do I roll it to my IRA? That’s the most common option. You can also leave it in the company plan if you like. Or maybe you got a new job; roll it to a new company plan. Or take a lump-sum distribution, there are some tax benefits on that. And once you’ve exhausted all of those, then look into the IRA rollover.
• If you keep rolling an old 401(k) over to an IRA, you could have a nice IRA. But if you keep taking it out and spending it and you keep changing jobs, at retirement, you’ll have spent most of it and cost yourself a fortune in taxes.
• If you don’t have an IRA, set one up, but do a direct rollover. Don’t take the funds out and roll it over yourself because then you’ll fall into the 20% withholding trap. The plans are required to withhold 20% for taxes.
• If your company has a Roth 401(k), as many companies do now, you can do an in-plan conversion from your 401(k) to your Roth 401(k)—but it’s a Roth, and you’ll pay tax on that conversion—or an outside conversion where you convert right from the 401(k) to your own Roth IRA because you want to have it in your own Roth IRA rather than the company Roth 401(k).

Christine Benz: Hi, I’m Christine Benz for Morningstar. The typical worker has 12 jobs over his or her lifetime, which means that a lot of people are grappling with what to do with old 401(k) plans. Joining me to discuss that topic and share some guidance is tax and IRA expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: All right. Thanks, Christine.

Old 401(k)s

Benz: We want to talk about old 401(k)s, which are really an issue. People have more jobs than they used to over their lifetimes. And then we’ve also had some layoffs recently. Let’s talk about that.

Slott: For some reason in 2023 and even early in ‘24, there’s been a wave of layoffs. I saw this—and this is unbelievable—the tech industry, and you’re talking about the most profitable and valuable companies in the world—Microsoft, Google, Amazon—260,000 layoffs in 2023. And my source for that is a website, believe it or not, that has popped up, Layoffs.fyi, that tracks layoffs at companies. But there were other big stories. Citibank laid off 20,000 people, 10% of their workforce. UPS—I don’t get this one, everybody gets boxes every day, packages—laid off 12,000 people. This one is interesting because I wanted to know how could that be. Everybody is on Amazon every day. And the reason was a lot of people are going back to the office, not working at home, so not as many packages, But I don’t get it. Even Wayfair, I just saw laid off 1,750 people, 10% of their workforce. Macy’s, 2,350, and on and on. I don’t know why, but it’s happening.

And once you’re laid off, then as you said, Christine, you do have an old 401(k). And what do you do? Now you have options. Do I roll it to my IRA? That’s the most common option. And that’s almost like the default option. But not so fast. You should consider other options. You can leave it in the company plan if you like, or maybe you got a new job, roll it to a new company plan, or take a lump-sum distribution, there are maybe some tax benefits on that. And once you’ve exhausted all of those, then look into the IRA rollover. But it’s probably going to be the IRA rollover. But look at all your options. And the reason I say that is the IRA rollover is generally the final resting place because once you do that, that’s probably going to be irrevocable.

Tax Implications

Benz: I do want to delve into some of these, Ed. Starting with that lump-sum distribution, I think that might seem especially compelling to younger workers where maybe it’s not a lot of money, maybe they have credit card debt or student loans. It might seem like a good idea to take the money and run and use the funds for some other reason. Can you walk through the tax implications of that decision?

Slott: That’s what the industry calls and the pension industry calls leakage. It’s not a good thing because they might have $2,000, 3,000, 5,000, like you said. And they say, “Oh, what the heck? I’ll just take the money out,” and as you said, pay some bills or go on vacation or whatever. But that’s taxable. And younger people may also be subject to a 10% early withdrawal penalty under 59.5, plus taxes. They don’t think it’s a lot. But as you said upfront, I think you gave the statistic, that some people have over 12 ... what was that stat?

Benz: Twelve jobs. And younger cohorts, I think have even more over their lifetimes, or will have.

Slott: Right. So, they say $5,000 here, $3,000 here, it adds up. If you keep rolling it over, say to an IRA, you could have a nice IRA. But if you keep taking it out and spending it and you keep changing jobs, at retirement you’ll have spent most of it and cost yourself a fortune in taxes. So, that’s one way with the lump-sum distribution.

But I was thinking about the other way, the people that have been with the company many years. Because when you take a lump-sum distribution, generally you’re going to pay tax on that because most of it is pretax money. So, why would anybody take a lump-sum distribution other than the situation we just talked about, the smaller amounts? But what if somebody has $300,000, $500,000, $1 million? Who would take down a million and pay all that tax? There may be a situation for employees who have been with the company for a while and have built up stock in their company. So, they work for the company and a lot of times they have company stock. In other words, if they work for IBM, they have IBM stock; if they work for Microsoft, they have Microsoft stock in their 401(k). There are big tax benefits that you should look at before rolling to an IRA. This is one of these situations. If you roll to an IRA, the tax benefits I’m going to tell you about are off the table, irrevocable.

The tax benefit is known as NUA, net unrealized appreciation, in employer securities. Believe it or not, it’s been around for a long, long time, but still not that well known. And basically, the big benefit is, if there’s high appreciation and you qualify in the company’s stock, you can get a lot of that appreciation out at capital gain rates. If you rolled everything to an IRA, everything that comes out of the IRA is going to be ordinary income as opposed to long-term capital gain.

Let me give you an extreme example just to make the point. Let’s say an employee, a longtime employee—and we’ve seen some numbers like this with the runup in the markets the last 10 or 20 years—somebody working there a while, they have $1 million in their 401(k), of which their cost, when they put the stock in, the company’s stock was only $100,000. So, they have $900,000 of appreciation. That’s called NUA, net unrealized appreciation, in employer securities. If they opt for a lump-sum distribution rather than doing the IRA rollover, they take it, they take the stock out as stock. You don’t sell it in the plan in-kind as stock, and you move it to a taxable brokerage account, you only pay tax on the $100,000 cost. The other $900,000 you don’t pay any tax on until you sell it. And whenever you sell it, you qualify for long-term capital gain rates, which in some cases can end up half of what you would have paid coming out of the IRA. Now, there are a lot of steps to come. to qualify. The first question you have is, do you have highly appreciated stock? In my example, I gave it as an extreme example. Yeah, you have highly appreciated stock. It really pays to pay the tax on the $100,000 to get $900,000 out that can qualify for long-term capital gain rates.

But what if I switch the example and the cost was $900,000 out of the million? I wouldn’t tell somebody to do that, pay tax on $900,000 just to get the other $100,000 out at capital gain rates. So, you have to gauge what you consider. It’s very subjective. If it’s in the middle, highly appreciated stock, and it’s not an all-or-nothing. You can roll some of that to an IRA, but if you do, then that tax break is off-limits. It’s irrevocable in the IRA. Can’t go back on that. But it’s something you should look at.

You have to have a triggering event, a qualifying event. One of them is layoffs. That’s the most common, separation from service, or 59.5, death, or disability. But the most common one is separation from service. If you’re watching this and you were one of those 260,000 tech employees I just talked about, good chance you have some high appreciation in those companies we talked about and should look. I would never try this at home. Work with a competent advisor because there are a lot of ways you can mess up the rules. The distribution to qualify has to come out in one calendar year. It doesn’t have to be the calendar year after your separation, any calendar year, but it has to come out all in one year. There are a bunch of other rules. And many times, you actually have to convince somebody at your company that this break even exists. I’ve had years where I had clients sitting here and I had to get the company—eventually, you get to somebody who knows this. And I had to make calls. My average, I think I tracked it over time, was seven different calls to get to the one person in the company who said, “Oh, we know all about that.” But that’s the one person for 300,000 employees. Many don’t even know to ask. So, that’s an option. You may have been laid off, but there could be a silver lining, a big tax break. You don’t get that if you roll it over to an IRA.

Restricted Stock Units

Benz: And this does not pertain to restricted stock units or something like that held outside of the confines of the 401(k) realm?

Slott: No, no. And it has to be stock of the company you’re working for. When I say stock, people say, “Well, I have stock in my old 401(k).” No, only the stock in the company you’re working for is what we’re talking about here.

There’s another reason you may not do an IRA rollover: You were laid off and you want to keep it in the plan. You like something about the plan. Maybe you like the federal creditor protection, maybe you like the investments, whatever it is. That may be a reason to keep it in the plan, reasons to roll to an IRA, you have more consolidation and control. The RMD rules work better. They’re all consolidated. For example, if you want to do QCDs, qualified charitable distributions, are only available from an IRA. That may be a reason to roll to an IRA. So, there are reasons for each option that you have to explore. And this is something you want to work with a competent advisor because this is where you may need help. I don’t know if this is do-it-yourself stuff because the sums are so large. Remember, this is basically your life savings. The rules are complex, and you may only have one chance to get it right.

What to Know When Doing a 401(k) Rollover

Benz: Right. I wanted to discuss the rollover, which is, I think, the option that many employees choose. So, I’m just finding an investment provider and working with them to set up an account there, and that in turn is the receptacle for those 401(k) assets. Is there anything else I should know when embarking on that?

Slott: Or an existing IRA you might have. You might already have. A lot of people already have IRAs, and they call whoever they’re with, whatever custodian or financial institution they’re with. Like you said, if they don’t have any IRA, which is unlikely these days, set up an IRA, but do a direct rollover. Don’t take the funds out and roll it over yourself because then you’ll fall into the 20% withholding trap. The plans are required to withhold for taxes 20% if you take a check, if you say, “Give me a check made out to me.” Because under the tax rules, that rule was created because they don’t know if you’re really going to roll it over. Do a direct transfer to the IRA and you’ll avoid the 20% mandatory withholding.

Should the Old 401(k) Funds Be in a Roth or Traditional IRA?

Benz: Another fork in the road that someone will hit if they’re doing a rollover is, do you want the funds to be Roth or traditional? It raises the question of conversions at that point that you do a rollover. Can you provide some coaching on how to think about that question?

Slott: You just added two more options. I was only going to go four. And if you’re keeping score, now we have six options. Number one was the IRA rollover, which is probably best for most people. I think that’s the default choice if there’s no bigger benefits than the others. The other five—we have six because you just added two—number two was keep it in your 401(k); number three, roll it to a new company’s plan; number four is take a lump-sum distribution.

Now we have two more Roth options. You can do an in-plan Roth conversion within the company. Let’s say for some of those reasons I mentioned, you want to keep it with the company. If your company has a Roth 401(k), as many companies do now, you can do an in-plan conversion from your 401(k) side to your Roth 401(k), keeping it within the plan, but now it’s a Roth and you’ll pay tax on that conversion, or an outside conversion where you convert right from the 401(k) to your own Roth IRA because you want to have it in your own Roth IRA rather than the company Roth 401(k). Now you have six options to consider what you’re going to do with what may be the largest check you ever receive.

Benz: This is obviously a complicated topic. Ed, thank you so much for being here to share your insights.

Slott: All right. Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.

Watch Brace Yourself for Higher RMDs in 2024 for more from Christine Benz.