Understanding Severance Packages, Part 2: What Happens to Your 401(k)

Whether it comes after a year, a decade or a whole career, being dismissed from your job is never easy. Routines are upended, relationships are disrupted, and your sense of identity may take a hit. Your next step could be a job in the same field, a new career path, an entrepreneurial project or perhaps even retirement. But while you think it over, you’ll also have some important financial issues to consider.

Welcome to the second article in a five-part series about severance-related issues that you should know about if you ever find yourself in this challenging position. Today, we discuss the potential impact on your 401(k). Each retirement investor’s situation is unique, so we recommend speaking with an advisor to discuss the options for your retirement investments.

Before you leave

A 401(k) plan tax-efficiently builds wealth for retirement and is often supplemented by matching employer contributions. Once your separation date is confirmed, it’s generally best to fund the maximum allowable amount to your 401(k) plan before that date. It’s a great retirement savings opportunity that will soon be lost, so take advantage of it while you can—as long as it fits your financial circumstances.

If a paycheck adjustment that reduces your take-home pay is required before year-end, remember that you’ll be receiving a severance payment shortly after separation, which can help offset the impact.

Some 401(k) plans allow you to choose between traditional pre-tax contributions and Roth 401(k) contributions. If you have not already done so, switching your remaining contributions to traditional pre-tax can help reduce your taxable income for the year.

What to do with your 401(k)

After leaving your company, you have several options regarding your 401(k) plan. First, it might be possible to leave your account in the company plan. Plan terms vary, so consult with your employer or plan administrator to understand what is available to you.

If you can keep your plan at the company, it will remain invested and continue growing on a tax-deferred or tax-free basis, depending on whether your contributions were traditional or Roth. You’ll continue to have online access, and you will not be required to take distributions until age 73, which is the current age at which Required Minimum Distributions (RMDs) must begin under SECURE 2.0.¹

If you’re between ages 55 and 59½, consider whether you might need to withdraw from your 401(k) before age 60. Generally, withdrawals from a retirement account before age 59½ are subject to a 10% early withdrawal penalty. However, the “Rule of 55” allows penalty-free withdrawals from your 401(k) if you separate from service in the calendar year you turn 55 or later.² Because this rule applies only to the 401(k) of the employer you just left, you may want to keep some or all funds in that plan if early access could be helpful.

A second option is to roll over your 401(k) into another company’s 401(k) plan or an IRA and/or Roth IRA. The components of your 401(k) deposits will determine what type of account the money should be rolled over to while avoiding taxes. Generally, pre-tax dollars should be rolled over into a traditional IRA, with the check made payable to the IRA custodian. Any Roth 401(k) dollars should generally be rolled to the custodian of a Roth IRA.

Lastly, if you have an after-tax account where you made after-tax contributions over the years, consider rolling those contributions into your Roth IRA. This strategy—sometimes referred to as the “mega backdoor Roth”—can allow high-income earners to build Roth assets even if income limits prevented direct Roth IRA contributions. The after-tax contributions themselves may also be taken as cash into a checking or brokerage account if desired.

We’re here to help

Over the years, our team has helped many executives and professionals navigate the complicated and often overwhelming severance process. We’ll develop a personalized strategy, including investment recommendations, to help you make the most of your severance package and position your finances for long-term success.

Are you wondering what to do with your 401(k) and which rollover decisions best suit your circumstances? Contact a Corient Wealth Advisor today. 

¹ https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs
² https://www.irs.gov/taxtopics/tc558

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