When leaving an employer for a new job, your 401(k) remains in the former employer’s plan. Only when you designate to roll over the 401(k) will the account’s assets be moved. There are four 401(k) rollover options. Each option should be reviewed carefully to make the right choice for you. Read below to review the four options.
Option 1: Roll into New 401(k) Plan
When considering this option compare the former plans investment choices and fees to the new plan. As a general rule of thumb, the fees for a large company’s 401(k) plan are usually lower than for a smaller company’s plan. This is because, in most cases, the plans administrative and recordkeeping costs are passed to the employees. The more participants in the plan, the lower the cost for each individual.
The second fee to consider is the investment options expense ratios. You don’t have to compare all the investment options expense ratios, just compare the funds that you’re invested in, and the funds you plan to invest in within the new 401(k).
Some 401(k) plans lump both of these fees together into the expense ratio of the funds. In this case, you’ll see expense ratio’s north of 1-1.5%. Plan sponsors are seemingly trending away from this because it’s not nearly as transparent as splitting the fees apart.
Finally, you’ll want to consider if it’s worth the time monitoring two 401(k)s. If the fee and investment option difference isn’t significant, you still may want to consolidate in the new employer’s plan for the sake of saving time.
Option 2: Roll into an IRA
An old 401(k) can be rolled into its corresponding IRA or Roth IRA. If you have a traditional pre-tax 401(k), and a Roth 401(k), each account should be rolled into an IRA or Roth IRA to maintain its tax-deferred or tax-free status. To ensure the assets don’t lose their tax status, make sure the assets are deposited into their corresponding IRA within 60 days. Doing so will also avoid the costly 10% early withdrawal penalty.
Rolling into an IRA opens up the investment options available. In 401(k)’s you’re limited to the investments offered in the plan. Typically 20-30 options. IRA’s can invest in individual stocks, bonds, mutual funds, index funds, ETF’s, and the vast array of other options.
The fees associated with an IRA are determined by whether you DIY or open an account with an adviser or robo-adviser. If you DIY, you’ll pay transaction fees per trade. If you hire an adviser or robo-adviser, they’ll likely charge an asset management fee. Anywhere from 0.25-1.5% of assets they manage. This is in addition to the expense ratio of any funds, or ETF’s you may invest in. However, keep in mind the advice and guidance received from a competent advisor is well worth the cost if you have no interest, or no clue what you’re doing.
Lastly, by rolling into an IRA, the account loses the ability to borrow against it, and a certain level of protection from claims by creditors. In a 401(k), the only entities that would have claim over your assets are the IRS and an ex-spouse as the result of a divorce proceeding. Meaning, if your employer were to go bankrupt, 401(k) assets are protected. In an IRA, the assets have an unlimited amount of protection against bankruptcy claims as well. However, depending on the state you live in, it can lose non-bankruptcy protection.
In most cases, the more investment options and ability to control fees can outweigh the ability to borrow and creditor protection features when considering to roll into an IRA.
Option 3: Keep assets in old 401(k)
Another option is to not do anything. Maintaining assets in your old 401(k) can be an option if the old plan doesn’t force the assets out. This can happen if the asset size isn’t very big. In certain cases, companies will do this so they don’t have a bunch of $2,000 401(k)’s they have to watch over.
If your new employer has higher fees or poor investment options, you may consider leaving the assets. They also may have investment tools or resources you want to maintain access to. Keep in mind, once you leave an employer you can no longer contribute to that 401(k). If you choose this option, it can also be a hassle to have to manage an old account.
Naturally, you may not pay attention to it at all, potentially leaving the account vulnerable to risks you aren’t comfortable taking.
Option 4: Cash Out
For the vast majority of situations, the last option is probably the one you’ll want to avoid. You’ll be severely taxed by making distributions from a 401(k). The federal tax penalty for early withdrawals from qualified retirement accounts is 10%. If you withdraw $10,000 from a 401(k), in addition to paying income taxes, you’ll also owe another $1,000 per the penalty. This should be avoided at all costs, it’s a waste of money.
There are exceptions to avoiding the penalty, but Congress enacted the penalty for a reason. Retirement accounts are meant for retirement, not for liquidity purposes before retirement. Cashing out should be a last resort.
If you have further questions or would like to discuss your rollover options, please feel free to schedule a free consultation with us today.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!