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Letting money sit tight in an old 401(k) plan is the path of least resistance, which is why many participants let their assets sit in the plans of former employers. This, of course, may be better than cashing the money out and spending it. Investors younger than 55 pay ordinary income taxes and a penalty on any premature distributions, which can diminish a 401(k) balance considerably. But there are also other reasons why staying put in a former employer's plan may be the best course of action.
1) Investors can't buy comparable investments on their own. One of the key reasons to stay put in a former employer's plan is if it offers investment options that are unavailable to smaller, individual investors. Institutional share classes of funds, which typically feature very low costs, are one such example. Another reason to leave money behind in an old 401(k) plan is to take advantage of a stable-value fund. This may be important for investors who are nearing retirement and looking to keep their portfolios steady, but not for younger employees who may not have such a great need for stability.
2) Investors may need early access to their money. Investors in 401(k) plans who have left their employers have another lever that IRA investors do not: the ability to tap their assets a touch earlier—at age 55 (Source: IRS 401(k) Resource Guide - Plan Sponsors, General Distribution Rules). To be eligible, workers must reach age 55 (or older) sometime during the year they retire. By contrast, IRA investors and 401(k) investors who retire before age 55 must wait until age 59 1/2 if they want to avoid the 10% early withdrawal penalty. Thus, for an investor closing in on that age who would like to have access to cash, staying put in the previous employer's 401(k) will make more sense than rolling the money over. However, it is a good idea to fully assess the portfolio's long-run sustainability before contemplating withdrawals at such an early age. Also note that some 401(k) plans may not allow the age 55 withdrawal option.
3) Investors could need the extra legal protections. Legal protections are another reason to consider staying put in an old 401(k). Although laws regarding creditor protections for retirement assets vary by state, company retirement plan assets generally have better protections from creditors and lawsuits than do IRA assets. Obviously, these protections will be a bigger consideration for those who have had credit or bankruptcy problems or who work in a profession where they may be sued.
4) Investors own company stock in their 401(k)s. When employees hold company stock in their 401(k) plans, staying put may offer a tax advantage versus rolling the money over. When company stock is held in a company retirement plan, stockholders pay capital gains tax on any appreciation over and above their cost basis when they sell the shares to take distributions in retirement (This differential is called net unrealized appreciation, or NUA). When rolling over the company stock into an IRA, on the other hand, stockholders pay ordinary income tax on the distributions they take when in retirement.
5) Investors may need the structure. Keeping the money in a 401(k) plan can provide at least a few safeguards. After all, these plans are overseen by fiduciaries who are legally required to look out for participants' interests, so the funds in the lineup tend to be well-diversified. However, investors should be aware that there may be differences in fees and expenses between 401(k) and IRA plans, and should investigate these fees and expenses carefully before making a decision.
401(k) and IRA plans are long-term retirement-savings vehicles. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Please consult with a legal, financial, or tax professional for advice specific to your situation.
