When Can You Lose Control Over Your 401(k)?

Reviewed by David KindnessFact checked by Kirsten Rohrs SchmittReviewed by David KindnessFact checked by Kirsten Rohrs Schmitt

If you have a 401(k) plan, you probably know the basics. What you might not know is when you can lose control over your 401(k). Though this is rare, and your funds are safe, it’s important to understand two unique situations: when you leave your company, and when you borrow from your account.

Key Takeaways

• After you leave the company, if your 401(k) balance is less than $1,000, your employer can cut you a check.
• Your employer can move the money into an IRA of the company’s choice if your balance is between $1,000 and $5,000.
• For balances of $5,000 or more, your employer must leave your money in the 401(k) unless you provide other instructions.

When You Change Employers

Your employer can remove money from your 401(k) after you leave the company, but only under certain circumstances, as the Internal Revenue Service (IRS) explains.

If your balance is less than $1,000, your employer can cut you a check for the balance. Should this happen, rush to move your money into an individual retirement account (IRA). You typically have just 60 days to do so or it will be considered a withdrawal and you will have to pay penalties and taxes on it. Note that the check will already have taxes taken out. You can reimburse your account when you reopen it.

If your balance is $1,000 to $7,000, your employer can move the money into an IRA of the company’s choice.

These mandatory distributions, also called involuntary cash-outs, have different thresholds, depending on what your employer has chosen. Your company doesn’t have to require cash-outs at all, but if it does, the highest allowable threshold is $7,000. Your summary plan description should spell out the rules, and your plan sponsor must follow them. The plan sponsor must notify you before moving your money, but if you don’t take action, your employer will distribute your balance according to the plan’s rules.

However, there’s a caveat, according to Greg Szymanski, director of human resources at Geonerco Management LLC: “These vested account balances are evaluated each year based on plan documents. So someone not in an auto cash-out or auto rollover this year may find him- or herself in that position the following year if the stock market declines.”

The $7,000 rule only applies to money deposited into your 401(k) from earnings from the job you just left. Say you rolled $8,000 into that 401(k) from a previous employer and contributed $4,000 after that. Your 401(k) balance would be $12,000, but as only $4,000 was from the job you just left, you could still have your money moved to a forced-transfer IRA.

Note

Employers make these rules because it costs them money to manage each account. They also incur legal responsibility with every account they manage. Many employers want to eliminate those costs and responsibilities when it comes to former employees.

When You Borrow

Some employers choose to offer 401(k) loans. If they do, they also have some control over which rules to apply to repayment.

According to Michelle Smalenberger, CFP, “Your employer may refuse to let you contribute while repaying a loan.” Smalenberger is the cofounder of Financial Design Studio, a fee-only financial planning and wealth management firm. “When an employer chooses what plan they will offer or make available to their employees, they have to choose which provisions they will allow,” she says.

“If you can’t contribute while repaying, remember that your employer is giving you a benefit by allowing the loan from the plan in the first place,” she adds.

And if you can’t make contributions while you’re repaying your loan, be aware that a higher amount of your paycheck will go to income taxes until you resume contributions.

If your employer does allow plan loans, the most you can borrow is the lesser of $50,000 or half the present value of the vested balance of your account, minus any existing plan loans. You must repay the loan within five years. And taking a loan puts you at risk of facing the obligation to repay it within a narrow time limit, typically until the next tax day, if you are laid off or quit.

It’s also important to know about another way you can get money from a 401(k): a hardship withdrawal. This type of withdrawal is not a loan. It permanently reduces your account balance. If you make one under certain circumstances, you may avoid a penalty, though you may owe income taxes. If your employer chooses, it can also refuse to let you contribute to your account for at least the next six months after a hardship withdrawal.

How Does a 401(k) Work?

With a 401(k), your employer withholds pretax dollars from your paycheck and deposits the money into an account where you can invest it. You get to decide what percentage of your paycheck goes toward your 401(k), and your employer might make matching contributions. The money grows tax-deferred until retirement, when you’re required to withdraw a certain amount every year and pay taxes on it.

What Is the Involuntary Distribution Limit for a 401(k)?

The SECURE 2.0 Act raised the mandatory distribution limit from $5,000 to $7,000, beginning with 2024. If your balance is $7,000 or more, your employer must leave your money in your 401(k) unless you provide other instructions.

What Should I Do if My Former Employer Rolled Over my 401(k) to an IRA?

Should your account end up in a forced-transfer IRA, you have the right to remove it to an IRA of your choice. Look carefully at the fees being charged. You may be able to do better on your own.

The Bottom Line

When it comes to 401(k) plans, it can be challenging to understand the rules. That’s why it’s important to do your research to figure them out, so you don’t incur any taxes or penalties you weren’t expecting.

Read the original article on Investopedia.