Posted by Authored by Kairvi Tijoriwala
A 401(k) plan can seem like a fairly straightforward retirement savings plan where money comes out each paycheck, an employer might make a matching contribution, and the invested money grows over time. Most employees sign up for their employer’s 401(k) plan during onboarding and probably don’t think about it again until something real comes up. What happens when an employee changes jobs? Can the money simply be moved to the new employer’s plan? Can the employee take out the money instead? How much can the employee contribute in the first place? The answers to all these questions depend on the terms of the plan as well as federal tax and ERISA rules. For attorneys who do not regularly practice employee benefits law, understanding a few 401(k) fundamentals can be useful, not only for navigating their own retirement benefits, but also when these issues arise in employment, divorce, estate planning, tax, and other areas of practice.
The plan document and the SPD are not the same thing
Plans that are subject to ERISA are required to be established and maintained pursuant to a written instrument. The plan document is a legally binding agreement that outlines how the retirement plan is operated and administered, including key terms such as eligibility, vesting, contribution limits, and distribution rules. It is a dense document and that is why ERISA requires employers to also provide a “Summary Plan Description” (SPD) to participants as well. An SPD conveys plan information in an understandable way to participants – it summarizes the information in layman terms such that an average plan participant can understand it. It is worth spending some time reviewing your SPD as it will provide important plan information.
Vesting Schedules
Vesting is when the employer’s matched money becomes yours. Whatever you personally contribute from your paycheck is always 100% yours. The vesting schedule requires employees to stay at a job for a certain amount of time in order to keep the full match. Vesting schedules can vary and that is why it is important to note them, especially if you’re considering leaving your job, as it can save you from walking away from money. Plans typically use either “cliff” vesting (you get 0% until a certain point, like three years, then jump to 100%) or “graded” vesting (a percentage each year, say 20% annually over five years).
Contribution limits change every year
401(k) plans have contribution limits and the IRS adjusts the annual limit on employee contributions for inflation. Individuals who are age 50 or older can make an additional annual contribution, called “catch-up contribution.” There’s also a combined limit, employee plus employer contributions together, that’s higher still. It’s worth checking the current-year numbers directly with your plan administrator or on the IRS website since these figures shift annually.
Rollovers: the part that trips people up
When you leave a job, it is important not to forget about your 401(k) plan. Employees generally have four options for an old 401(k): leave it in the former employer’s plan (if the plan allows for it), roll it into your new employer’s plan (if the plan accepts rollovers), roll it into an Individual Retirement Account (IRA), or cash it out. The first three are typically tax-neutral if done correctly. The fourth, cashing out, can trigger taxes and penalties depending on ones age and tax situation.
The transfer of funds between a 401(k) and IRA can be a direct or indirect rollover. In a direct rollover, the funds move institution-to-institution and there is no tax withholding. In an indirect rollover, a check is made out to the employee personally, and the plan is required to withhold taxes, even if the intent was to roll the entire amount over. Employees then have 60 days to deposit the full original amount (including the 20% that was withheld, which you’d need to cover out of pocket) into a new retirement account, or the withheld portion is treated as a taxable distribution, and possibly penalized if you’re under 59½. People often assume they just need to deposit the check they received; they don’t realize the IRS treats the withheld portion as still owed.
The fix is simple: whenever possible, ask for a direct rollover. It avoids the withholding issue entirely and removes the 60-day clock.
Roth vs. traditional matters at rollover time
If you have a Roth 401(k), it needs to go into a Roth IRA (or Roth account at the new employer) to preserve its tax treatment. Rolling Roth funds into a traditional account, or vice versa, without doing it correctly can create an unintended taxable event.
None of this requires a finance or ERISA background. It just requires reading the documents you already have and asking your plan administrator the right questions.
About the Author
The views and opinions expressed here are my own and do not represent the views or opinions of
my employer.
Kairvi Tijoriwala is a healthcare regulatory attorney licensed in Illinois and works as in-house counsel in the Chicago-area. Prior to healthcare, she worked as an employee benefits associate at a big
law firm.