Breaking Up With Your Employer Is Easy. Deciding What to Do With Your 401(k) Isn't.

You turned in the badge. You updated LinkedIn. You survived the goodbye-cake speech. But you may have left something behind at your old job — and it might be one of the most valuable things you own: your 401(k).

If you’re not sure what to do with it, you’re in good company — and that company is making some questionable choices. When researchers tracked 162,360 employees leaving 28 U.S. companies, they found that 41.4% cashed out at least part of their 401(k) on the way out the door — and most of those savers drained the entire balance. Harvard Business Review didn’t title its write-up “Too Many Employees Cash Out Their 401(k)s When Leaving a Job” by accident.

The good news: you generally have four options, and understanding them takes about five minutes. The trapdoor is behind door number four, so let’s take them in order.

Option 1: Leave it in your former employer’s plan

Think of this as the houseplant strategy — perfectly reasonable, as long as somebody remembers to water it. If the plan allows it, your money can stay put and keep growing tax-deferred. Some plans offer institutional-class funds with low costs, and workplace plans generally carry strong federal creditor protection.

The catch: you can’t contribute to it anymore, it’s one more account to track (orphaned 401(k)s are a real phenomenon — people forget them like gym memberships), and if your balance is under $7,000, the decision may not be yours. Federal law permits plans to “force out” small balances: amounts under $1,000 can be cashed out and mailed to you, while balances between $1,000 and $7,000 can be automatically rolled to an IRA of the plan’s choosing — not necessarily one you’d pick.

Option 2: Roll it into your new employer’s plan

If your new job offers a 401(k) that accepts incoming rollovers, consolidating can mean one statement instead of a drawer full of them. Money in a current employer’s plan also keeps certain plan-only features, such as the potential for penalty-free withdrawals if you separate from service in or after the year you turn 55 (the so-called “Rule of 55”) — a feature IRAs don’t offer.

The trade-off: your investment choices are limited to the new plan’s menu, and plan fees and features vary. If you go this route, ask for a direct rollover — the money travels trustee-to-trustee and never touches your hands. (More on why that matters in a moment.)

Option 3: Roll it into an IRA

An IRA typically offers the widest investment menu and lets you consolidate accounts from multiple old jobs in one place. The tax mechanics depend on what kind of 401(k) you have: a traditional (pre-tax) 401(k) can roll to a traditional IRA with no tax due today, and a Roth 401(k) can roll to a Roth IRA. Moving pre-tax 401(k) dollars into a Roth IRA is a conversion — permitted, sometimes strategic, but never free: you’ll owe ordinary income tax on the converted amount in the year you do it.

IRAs come with their own trade-offs: no Rule of 55, creditor protection that varies by state rather than the blanket federal protection of a workplace plan, and fees and expenses that may be higher or lower than your old plan’s. “It depends” is doing a lot of work in this paragraph, which is rather the point.

One trap worth naming: if a rollover check is made payable to you instead of to the receiving institution, your old plan is required to withhold 20% for taxes. You then have 60 days to deposit the full amount — including the 20% you never received — or the shortfall is treated as a taxable distribution, potentially with penalties. A direct rollover sidesteps the whole mess.

Option 4: Cash it out

This is the trapdoor. Take the money and you’ll generally owe ordinary income tax on the full pre-tax amount, plus a 10% additional tax if you’re under 59½ (certain exceptions apply), plus that mandatory 20% withholding right off the top — and you forfeit years or decades of potential tax-deferred compounding. There are genuine emergencies where cashing out is a considered choice. More often, it’s the most expensive door in the hallway, which is why nearly half of job-changers walking through it keeps researchers up at night.

The plot twist: company stock and the tax break almost nobody’s heard of

If your old 401(k) holds shares of your former employer’s stock, there’s a fifth wrinkle: net unrealized appreciation (NUA), a special tax treatment under Internal Revenue Code Section 402(e)(4). In broad strokes: instead of rolling company shares into an IRA, you move them in-kind to a taxable brokerage account as part of a lump-sum distribution of your entire plan balance following a triggering event (such as separation from service or reaching 59½). You pay ordinary income tax now — but only on the stock’s original cost basis. The appreciation that built up inside the plan is taxed at long-term capital gains rates when you eventually sell, which can be meaningfully lower than ordinary income rates.

Whether NUA is brilliant or a blunder depends entirely on your situation: how low the cost basis is relative to today’s value, your current and future tax brackets, how concentrated your wealth is in one company’s stock, and your time horizon. And here’s the part that makes advisors sit up straight: once those shares are rolled into an IRA, the NUA option is generally gone for good. It’s a one-way door, and it deserves a real analysis — not a rule of thumb.

So… which door is yours?

The honest answer is that it depends on your taxes, your investment costs, your age, your protections, your company stock, and how this one account fits into everything else you’re building. The right move for your former coworker may be exactly the wrong one for you.

That's precisely what a wealth management plan is for. Before you move a single dollar, let's run the numbers together — all four options (and the NUA question, if it applies to you), side by side, in plain English.

Your 401(k) already survived one breakup. Let’s make sure it lands somewhere with a future.

Sources

Internal Revenue Service, “Rollovers of Retirement Plan and IRA Distributions” — irs.gov/retirement-plans/plan-participant-employee/rollovers-of-retirement-plan-and-ira-distributions

Internal Revenue Service, “Retirement Topics — Termination of Employment” — irs.gov/retirement-plans/plan-participant-employee/retirement-topics-termination-of-employment

Internal Revenue Service, Topic No. 413, “Rollovers from Retirement Plans” — irs.gov/taxtopics/tc413

Internal Revenue Service, Publication 575, “Pension and Annuity Income” (net unrealized appreciation and lump-sum distributions) — irs.gov/publications/p575

Wang, Y., Zhai, M., & Lynch, J. G., Jr., “Too Many Employees Cash Out Their 401(k)s When Leaving a Job,” Harvard Business Review, March 2023 — hbr.org/2023/03/too-many-employees-cash-out-their-401ks-when-leaving-a-job

Important disclosures

This material is provided for educational and informational purposes only and is not intended as individualized investment, tax, or legal advice, nor is it a recommendation to take any particular action with respect to your retirement account. Each option described (remaining in a former employer’s plan, rolling to a new employer’s plan, rolling to an IRA, or taking a distribution) has advantages and disadvantages — including differences in investment options, fees and expenses, services, protection from creditors, required minimum distributions, and tax consequences — that depend on your individual circumstances. Before making any decision, consider consulting a qualified tax professional. Wavvest Wealth is a registered investment adviser. Registration does not imply a certain level of skill or training. Investing involves risk, including the possible loss of principal. Tax laws are subject to change.