A good friend of mine recently went through a break-up…with her job. A break-up with your job has several similarities to a break-up with a boyfriend. Depending on how the break-up occurred you might have been blindsided, leaving you with unresolved feeling and questions of why? What could I have done differently? Or maybe you initiated the break-up and you’re just not feeling it anymore, it’s time to move on. But invariably there’s some sense of the feeling of loss; all that time, effort and maybe even money you invested into the relationship–gone? For nothing? At least in a work split, the money you invested in your 401k is wholly yours! But what should you do with the 401k after you leave your old job? That was the question I posed to my friend and she said cash out. Oh no no no. So, I told her I’d write a post about it. ? Let’s discuss your four general options below.
Leave it behind. You could just leave your 401k behind in your employer’s plan but you generally need to have a minimum balance (about $5000) or else your employer could force you out. This also may or may not be a good option since on one hand if you switch jobs fairly frequently and have multiple 401ks all over the place, you might lose track of them and forget to monitor them. Out of sight, out of mind. Also, I personally hate having multiple accounts/credit cards and believe in simplifying your finances. Additionally, an employer can charge you higher 401k management fees if you are not an active employee. On the other hand, if your old 401k plan was a really good plan with low fees and good or unique investment options (such as in a thrift savings plan), it might be better to just leave it as is. Especially if you have no idea how to invest your 401k money if you were to roll it over to an IRA. In a 401k, the money is probably being managed for you because well most people don’t do anything and the government and your employer realize this and so they just tend to put your money into default investments like a target date fund and sometimes even implement automatic increases in your paycheck deductions yearly to have you save and invest more. Not surprisingly a lot of people don’t even realize this is happening for them.
Cash Out. Generally a bad idea if you’re younger than 59.5 years old. Not only will you have to pay federal and state income taxes in your current tax bracket but also a 10% early withdrawal penalty fee. For example, if you had $50,000 in your 401k and decided to cash it out when you leave, and you’re in the 25% federal income tax bracket, by cashing out your 401k, you’d only get $33,750 after taxes and penalty. That’s not even including state income tax if you have to pay those. Consider also all the compounded tax-deferred growth you’d lose out on by cashing out early.
Rollover to your new 401k. Another option could be to rollover your old 401k into your new job 401k. However, this can only be done if your new employer allows this so check with the HR or benefits department. Also, there might be a waiting period (i.e. a year to be vested) before you can even do the rollover. The pros of this though would be that you can consolidate your retirement investments in one place, making it easier to keep track of and manage. But, what if your new 401k is worse than your old 401k? Or just plain bad. Bad means, high fees, loaded mutual funds, bad investment options. Then consider your fourth choice below.
Rollover to an IRA. Usually a traditional IRA, but if you did have a Roth 401k or Roth 403b then you could rollover into a Roth IRA too. If you want to rollover your 401k or 403b into a Roth IRA, this is considered a Roth conversion and you will have to pay taxes on the conversion at your current income tax rate. Still, this might be a good idea if you strongly believe you’ll be paying more taxes in retirement either because the government will increase taxes significantly or you’ll be in a higher income tax bracket. Also having money in a Roth IRA gives you tax diversity to hedge against future tax rates. You may want to only convert a portion of your 401k to a Roth and keep a portion in a traditional IRA. If you are unemployed for an extended period of time, it might also be a good idea to convert to a Roth IRA since your tax bracket for that year will be low (because of your unemployment).
The pros of rolling over your 401k to an IRA is (1) consolidating your money into one account, (2) thus allowing you to have better control over your investments, (3) while simultaneously gaining access to a greater variety and quality of investment options which are also probably lower in fees. Two major pitfalls with a 401k rollover into an IRA are (1) if you have no idea what to invest in and end up leaving it in a cash fund or making some wonky investment choices or (2) if you plan on doing a Roth conversion as in the case of a backdoor Roth IRA (though there is a workaround) which can trigger the pro-rata rule and additional taxes. Few other things to consider is that it’s generally a bad idea to have the check from your 401k plan made out in your name. Doing so requires your employer to withhold 20% of the funds and then leaves you only 60 days to complete the rollover, otherwise you’ll get slapped with the 10% penalty (if you’re under age 59.5) and have to pay federal and any state income taxes. You also have to come up with the withheld 20% of the funds on your own to complete the rollover, or that portion will be considered a distribution! You can avoid all this with a direct trustee-to-trustee transfer, if you have them write the check out to the IRA custodian of your choice. This of course requires you to know where you want to open your IRA at unless you have an existing one you’d like to transfer into. For example Vanguard asks you have the check addressed to Vanguard Fiduciary Trust Company FBO [your name]. Or better yet try to see if you can wire it directly into the IRA and avoid this whole check business. Lastly while there’s no limit on trustee-to-trustee transfers, the IRS has a new rule starting 2015 that you are only allowed one rollover per year for all IRA’s.
So there you go, four options for your old 401k. Don’t do the cash out unless you’re just that desperate for cash or age 59.5 and older. So you’re really left with three choices. Carefully take a look at your financial situation. If you do rollover or transfer into an IRA and need an easy fund to pick for the time being, I’d consider a Vanguard Target Retirement Fund based on your expected retirement date or a Vanguard Life Strategy Fund which has four categories based on whether you need income now or growth or a combination. Both these funds are all-in-one investment funds that are an easy and simple choice if you don’t know what to invest in and Vanguard usually has them relatively cheap compared to other firms. Other good companies to consider opening an IRA at are Fidelity and T. Rowe Price. But all these companies will help you pick investments for your IRA for free if you call them. T. Rowe Price is offering a free retirement consultation with a financial professional til April 18, 2016 tax day!
As for my friend, she decided she does want to rollover her 401k into a traditional IRA (whether she executes this without my prompting we’ll see ?). She knows she can also later roll it over into her new 401k (if her new employer allow this and remember only one rollover per year) or keep it invested in the traditional IRA which depending on her new 401k provider may be the better choice. Luckily, she has a small emergency fund in place allowing her some flexibility to enjoy her time off and consider a career change. And now having decided what to do with her old 401k one less financial thing to worry about.