Employment Termination & 401(k)s

Employment Termination & 401(k)s
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A 401k plan is a retirement plan that many employers offer as an added benefit to employees. Essentially, a 401k plan is a tax-advantaged investment account in which an employee can choose their own investment allocations from an offered list of choices. When employment is terminated, for whatever reason, an employee has a number of choices on how to handle the existing 401k balance.

401k Characteristics

A 401k plan is a tax-advantaged, employer-sponsored retirement plan into which both employees and employers can make contributions. Contributions are made with pre-tax dollars, and 401k assets grow tax-deferred until distribution. Employee contributions are made on a salary-reduction basis, meaning they are deducted directly from employee paychecks.

Definition of Employment Termination

If you switch jobs, are fired for any reason, or if your employer goes bankrupt, your employment has been terminated for 401k transfer purposes.

401k Transfer

A 401k is a type of "qualified retirement plan," meaning it can be transferred into most other types of qualified plans on a tax-free basis. If your new firm has a 401k plan, you can usually transfer your old 401k into it, and you can also transfer your 401k into an Individual Retirement Account (IRA). When you are terminated from employment, you can contact your 401k administrator to obtain the proper paperwork for your transfer. Some employers will send you the paperwork immediately after termination even without request, as many will not allow you to maintain your 401k once you separate from service.

401k Distribution

If your employment termination arises from retirement, you can simply take a distribution and cash out your 401k. Whatever amount you withdraw from the 401k will be taxed at ordinary income rates, and if you are under the age of 59 1/2, you will also have to pay a 10 percent early withdrawal penalty.

401k Loans

If you have an outstanding 401k loan when you terminate your employment, the loan must be paid back in a short period of time, usually 30 to 60 days. Each employer specifies different terms, but as you are no longer drawing a paycheck, there is no funding source for the loan payments, and most 401k administrators want your loan off the books as soon as possible. Failure to repay within the specified time will result in the loan being classified as a distribution, and you will owe income tax on the entire outstanding balance, in addition to the 10 percent early withdrawal penalty if you are under the age of 59 1/2.