So you have left your job and employer's 401k plan. Whether it was due to retirement or simply a job change, you’re probably wondering what to do with your old 401k. Should you just leave it there? Should you move it to your new employer’s 401k? Or should you roll it over to an IRA? It can be an overwhelming task to figure out your options and a confusing decision to make. These and other questions and concerns might leave you with “paralysis by analysis.”
Follow this advice to understand potential pitfalls of each option, and what benefits you might gain. The good news is that a little homework can likely lead you to the answers that are right for you and your retirement plan.
Keeping with your current plan, your 401k has protection from creditors, it might have lower fees than other options, and you can avoid early withdrawal penalties. Of course, this also means your investment options may be limited. You can’t take a loan from an old 401k, and if your account balance is less than $5000, your employer may not allow you to remain in the plan.
Keep in mind that if your old employer decides to change 401k providers, you would be forced into new investment options. In addition, your access to your 401k could be temporarily limited if your employer goes through bankruptcy proceedings. All of these possibilities would pose big challenges with you and your 401k, but the bottom line is that remaining in your old plan is still a valid option as long as you meet all the criteria your employer requires.
For those who change jobs, one option is to rollover your old 401k into your new employer’s plan. This has many of the same pros and cons as leaving the money in your old plan. The biggest advantage of rolling to a new plan is if your employer allows loans. Rolling your old 401k may give you a bigger balance so you have the ability to borrow more. Of course, borrowing against a 401k is rarely a wise option.
For many, rolling their 401k into an individually directed IRA could be the best choice. You get to continue tax-deferred growth, you avoid early withdrawal penalties, and you still have federal creditor protection. One of the biggest advantages is you get a much wider selection of investment choices that you can customize to fit your strategy. Also, you have much greater control over your assets, including the ability to consolidate them in one convenient place, and potentially with a trusted advisor.
There are some negatives, however. For example, you can’t borrow against your assets, and the costs may be greater than in the 401k. Despite these negatives, many people are leery about leaving money at an old employer, especially in retirement. Rolling into an IRA can allow much greater flexibility for a retiree to structure a retirement income stream.
One option that can be attractive—especially the younger you are—is to take an old 401k and convert it into a Roth IRA when rolling it over. Yes, you end up paying taxes now, but any growth of the Roth assets are tax-free (assuming that at distribution you have had a Roth for at least five years and you are over 59 ½ years old). This is an especially useful option if you are still early in your career and expect to be in higher tax brackets later, and even in retirement. In addition, having a pool of “tax-free” assets in addition to “taxable” and “tax-deferred” will give you greater income flexibility when you retire.
This may seem a bit self-serving, but get professional advice. IRA and tax regulations are complex and are constantly being revised. For example, the Supreme Court recently issued a ruling that affects Inherited IRAs. Therefore, it is easy for even very bright people to make planning and administrative mistakes when considering rolling a 401k to an IRA.The biggest reason to hire a professional wealth manager, though, is your trusted advisor can take this one event (the potential rollover) and give you advice based on the totality of your financial life. This type of holistic planning can help you make much better financial decisions.
Don’t just leave your old 401k where it is just because you are too busy with your new job or too lazy to deal with it. Whether your balance is small or large, this is your hard-earned money. So unless you have no issue with flushing money down the drain, make sure you at least work through what is best for you.
You might have a great reason for taking a cash distribution. Maybe paying off your mortgage or some credit card bills is a higher priority right now. Just don’t take a cash distribution for the heck of it. First, the 401k provider by law has to withhold 20 percent on a cash distribution (not so for a rollover!). Second, if you are under 59.5 the IRS will assess a 10 percent early withdrawal penalty with very few exceptions. Finally, taking a cash distribution disrupts what is supposed to be accumulation for your retirement years. Early cash distributions might mean a lower income in retirement or a much later retirement than desired. Be careful when looking at taking a cash distribution.
This is not an absolute don’t. If you retire or think you might retire between the ages of 55 and 59 ½, be very careful about rolling your 401k to an IRA. Remember, early withdrawals from an IRA will normally result in a 10 percent penalty. In a 401k, however, if you retire in the year you turned 55 or later, and your plan allows, you can take distributions between the ages of 55 and 59 ½ without the 10 percent early withdrawal penalty.
For example, let’s say a client retired at age 57 and he really wants the benefits of an IRA, but is concerned that he might need to touch some of his money. One strategy could be to leave sufficient assets in the 401k to accommodate his income needs up to age 59.5 and roll the remainder into an IRA.
Everything matters. One of the most dangerous assumptions is that it doesn’t matter which choice you make. The decisions you make surrounding what to do with your old 401k, and how to invest it, can have a profound impact on your future. Here is one example. A gentleman I met with in 2000 had his 401k invested 100% in his employer’s company stock, which was one of the hot tech stocks of that era. I recommended he diversify immediately and once he was able, potentially roll part of his 401k to an IRA to get even better diversification. He decided not to hire us and ignored our advice. Little more than a year later his $780,000 401k was worth about $88,000. And a year after that he was laid off. The point is it all matters.
Rollover paperwork was written by lawyers and sometimes that complexity is very evident. I have seen doctors and college professors check the wrong block due to the convoluted language in the rollover paperwork. One widow did it on her own and was surprised to find out she had opted for a cash distribution which resulted in 20% of her deceased husband’s 401k being sent to the government. One of the key advantages of hiring a financial professional who works with rollovers is that while you may do a rollover once or twice in your life, we may do it as often as once a month or once a week. We have usually seen most of the pitfalls and complexities surrounding this important event.
Whether you are entering on that grand adventure called retirement or simply changing jobs, deciding what to do with your old 401k is an important decision. Take the time to research your options carefully and, if appropriate, hire a trusted financial advisor to help you integrate this decision with your overall financial goals.
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