Most people don’t work for one employer their entire lives anymore. The days of people relying on a pension from their employer are seemingly coming to an end.
401k’s came into existence in the 1980’s. Since then most employers have made the move from defined benefit pensions to defined contribution 401k’s.
- Defined Benefit– A type of retirement plan in which an employee’s pension payments are calculated according to the length of service and the salary they earned at the time of retirement.
- Defined Contribution– A type of retirement plan in which the employer, employee, or both make contributions on a regular basis. Future values fluctuate based on investment earnings and contributions.
Back in the 1980’s, 401k’s were presented as giving employees the power to choose their own investments. In reality, they were oftentimes a modest cost savings to employers over their defined benefit counterparts since all employers aren’t required to contribute to an employee with a 401k. Typically the total employer contribution amount is lower as the employee is expected to contribute as well.
The 401k is designed for employees to save for themselves for retirement. The money the employee contributed can go with the employee when they leave the place of employment. The employer contribution is also eligible to go with the employee if the employer contribution is vested.
34% of employees say they plan to leave their current employer in the next 12 months according to Mercer. So wondering what to do with an old 401k balance can come up quite often as there are many people changing jobs that have balances in an old employer’s 401k.
There are four options that may be available to you when it comes to your old 401k: You can leave your account alone, roll it into an IRA, roll it into your new employer’s plan, or cash it out. We will walk through each here.
1) Keep your money in your former employer’s plan.
If you have a 401k balance over $5,000 you legally cannot be forced out of the 401k plan. If you have under $5,000, your employer has the option to cash you out of the plan which can potentially cause you issues you may not be aware of.
- You don’t have to do anything
- You are already set up to view your account.
- You can take penalty-free withdrawals from an employer-sponsored retirement plan if you leave your job in or after the year you reached age 55 and expect to start taking withdrawals before turning 59½.
Not So Good Things:
- Once you’re no longer an employee, your access to your money may be limited, you are no longer eligible for any loans, and you cannot add more money to the account. You may have to go through your old employer for any changes or requests.
- You have to remember to make sure your old employer has your current information such as your mailing address. This can be annoying if you have multiple 401k balances sitting out there. Plus, if your old company gets bought, changes plan providers, or the HR person changes, you may not have easy access to your login information or your new account number.
- Investment advice is typically done at employee education meetings at the business, so once you are no longer employed typically you aren’t attending these meetings.
- Plan may offer expensive investment options or lack investment options you want. Do you know the administrative costs the 401k passes to the participants? What about your mutual fund expense? See my blog about 401k fees here.
2) Move your money into an IRA
This choice gives you the most control and flexibility. With a 401k plan, the employer chooses the investments that are available in the plan and has more rules, with an IRA you aren’t limited to what the employer has chosen for the plan.
- Working with a financial advisor, you will have access to advice for your certain situation. This can be especially helpful if your 401k has been at your old employer for years and you are just now taking a look at the investments you were allocated into. It is also helpful if you are close to retirement age, to sit down with someone to discuss a course of action.
- Ability to combine multiple employers’ old 401k accounts into one IRA.
- Greater control over your investment expenses. 401k investment fees are in a participant fee disclosure, and in some cases they’re higher than what you’d pay for comparable investments outside the plan.
- Greater freedom to name beneficiaries. The beneficiary of your 401k plan, by law, must be your spouse; you have to obtain a signed release from him or her if you want to name anyone else. An IRA can be more flexible.
Not So Good Things:
- Taxes will be withheld unless you move the money from your 401k to an IRA via a trustee-to-trustee transfer. Not all recordkeepers will do this, and sometimes the check is mailed to the employee rather than the new IRA custodian. You have to make sure the money is in the account within 60 days, so the disbursement of funds aren’t treated as a withdrawal by the IRS.
- It can take a bit of effort to figure out how to move the accounts by yourself.
3) Move your money into your new employer’s 401k
You should certainly contribute to your new plan if your employer offers a match, but should you transfer your old account into it?
Most 401k’s allow you to transfer old employer’s 401k balances into it. Not all do though, so you should check with your new employer before you do so.
- Consolidating your retirement money makes it easier to view and manage. When you’ve left a retirement account at a company you no longer work for, you may pay less attention to its performance or downplay its importance in your overall picture.
- The new plan may offer more attractive investment options than the old one, as well as additional services, such as access to a financial advisor.
Not So Good Things:
- The financial advisor on the plan may not be a fiduciary. The advisor may just do group meetings with little access to personal advice for your specific scenario.
- The new plan may offer fewer investment options or investments that don’t meet your needs.
- Fees can be high in 401k plans; do you know the administrative costs the 401k passes to the participants? What about your mutual fund expense?
- Paperwork to move the money can be confusing and requesting certain documents and letters from the old 401k plan sponsor/recordkeeper can be tedious.
Generally, the smartest move is to evaluate the fees charged by the investments that you’d use in each plan and go with the plan that offers the lower-cost options. Again, the participant fee disclosure might not have all plan fees listed and it isn’t the easiest to determine.
4) Cash out the account
- It’s money you can use for other purposes.
Not So Good Things:
- You could no longer have any retirement savings.
- Distributions from your 401k could also push you into the next tax bracket, giving you a bigger tax bill.
- You will owe income taxes on your money.
If you’re in a 28% combined federal and state tax bracket, for example, and cash out a $40,000 account, you’ll have only $28,800 left after taxes. If you are under 59.5 there would also be a 10% penalty which would leave you with $24,800, far from the $40,000 you were expecting.
Not all of these options are available in everyone’s situation. If you find it confusing or overwhelming, I’d be happy to speak with you regarding your situation to help you with the decision, or to start the process.
The content of this article is provided for information and discussion purposes only. It is not intended to be a financial recommendation and should not be the sole basis for your investment or tax planning decisions.