Changing Jobs? Retiring? Laid off? What Do I do with my 401(k)?
As you may or may not know, your company's 401(k) is an account that is set up specifically to help you save for your (eventual) RETIREMENT. It's a great tool because of the automatic contributions from your paycheck, employer match, and tax-deferred growth (meaning you don't pay taxes on any of the money until you actually withdraw it).
If you've been at a company for some time, you may have gone back to check the balance recently and seen a nice chunk of change, primarily due to your diligence and some great market growth we've seen in the past decade. If you've been at a company for a REALLY long time, that may be a REALLY nice chunk of change.
If you're currently in a transitional period in your career, or planning on being in one soon, it is IMPERATIVE that you are fully aware of what your options are with this account. After all, it's YOUR money.
Here are the most common options at a 30,000 foot view:
-Keeping the account where it is
-Taking a full distribution (Usually not advisable, but an option nonetheless)
-Transferring it to a new 401(k) or other employer-sponsored plan
-Rolling the funds over into a Traditional IRA
-Rolling the funds over into a Roth IRA
This article will cover the pros/cons of each option, so you can be fully armed with the information necessary to make the best decision possible for yourself and your family.
Option 1: Keeping the Account where it is
It's only fair to let you know that you certainly don't HAVE to do anything with the account if you don't want to. Keep in mind, however, every company has its own specific rules when it comes to their 401(k) plan. Many plans include a "force-out" provision that essentially forces you out of the plan if you don't meet a minimum account balance requirement. Some plans may force you to take action regardless of your balance. Check your plan's Summary Plan Description for more information on this provision and anything else that is "plan-specific".
Assuming that you meet the minimum balance requirement, and your plan doesn't have some off-the-wall rules about moving the money, leaving the money in your company's 401(k) may make sense if:
-You like the investment options within the plan
-You like the functionality of the Plan Administrator's Website (i.e planning tools, etc)
-You want to 'punt' the decision and weigh out other options
Here are some notable "cons" to this option:
Note that some plans LIMIT YOUR FLEXIBILITY when it comes to DISTRIBUTIONS. Some plans are "all or none", meaning you either have to withdraw the entire amount at once, or none at all. Some plans only offer withdrawals once a quarter, etc. It's wise to check with your plan sponsor or Summary Plan Description for more information on your specific withdrawal options.
Also keep in mind that your investment options will be LIMITED to what is offered by the plan. Depending on where you're at on your path to retirement, you may require more individualized investment options that are tailored to your needs and risk tolerance.
Again, you need to decide whether or not you want to play by the "plan rules" when weighing out this option.
Lastly, keep in mind that you won't be able to contribute to the account or take loans from it if you are no longer active with the company.
Option #2: Taking a Full Distribution
When I was still practicing as a Financial Advisor, this is an option that almost never made sense. Let me explain:
Retirement accounts have the advantage of "tax-deferred growth". This means that none of the gains in the account are "realized" until you withdraw the funds. Hypothetically, you can grow the account balance from $0 to $100 million without paying a dime in taxes, UNTIL YOU WITHDRAW THE FUNDS. Remember, you can't avoid the taxes forever.
How does that work? Any amount that you withdraw from the account is added to your total income for the year of the distribution. For example, if you take a distribution of $50,000, Uncle Sam will say that you made another $50,000 of income that year (because we haven't paid taxes on those funds, assuming the contributions were made on a pre-tax basis).
As you can see, if you're not careful, you can bump yourself up to ANOTHER TAX BRACKET. Plus, the IRS requires plans to withhold 20% of the distribution for income tax purposes.
It is important to note that if you plan on doing an "indirect IRA rollover", you will have to come out of pocket for that 20% when depositing the funds into the new IRA before the 60 day window closes. If not, you may owe income taxes on that withheld amount, which wasn't deposited, on top of potential early-withdrawal penalties. Taxes aren't fun.
Always consult a tax advisor before making any decisions regarding your finances that may have severe tax consequences.
Option #3: Transferring the Account to a New Employer-Sponsored Retirement Account
If you're not retiring, and you're joining a different company that offers a 401(k) or similar type of employer-sponsored plan, a rollover to the new plan may be a viable option.
Here are some reasons why it may make sense:
-You value keeping everything together for the sake of convenience (especially if you don't like chasing around multiple statements from multiple accounts)
-You like the investment options offered by the new plan
-You like the tools/functionalities offered by the new plan
Here are some potential cons to this option:
-You may not like the investment options in the new plan
-The investment options within the new plan carry unreasonable investment expenses/feesSome plans don't allow for rollovers (most do, but again, check with your company's plan first)
-The new Plan Sponsor doesn't offer much help in terms of customer service, website access, etc.
There is nothing wrong with having multiple 401(k) accounts, but make sure that you stay on top of them. Ideally, you're checking your allocation (investment mix) in these accounts quarterly to make sure that it's still in-line with what's most appropriate with your risk-tolerance and retirement goals
Option #4: Rolling over the funds into a Traditional IRA
Throughout this article, we've seen a common trend around 401(k) plans as a whole: lack of FLEXIBILITY and having to play by PLAN RULES. The IRA gives you all of the flexibility in the world. Here are some things to consider.
Some Potential "Pros" to a Traditional IRA rollover:
If you're approaching retirement, you may require much more individualized care regarding the assets you've worked your entire career to accumulate. You may want more options instead of a basket of mutual funds to pick from. You may value having a single point of contact, or advisor, that knows you, your goals, your risk-tolerance and your needs.
You may also value unlimited flexibility in terms of distributions.
Remember, some plans may limit this, and impose a mandatory 20% withholding on the amount that you intend to distribute. For example, if you want to withdraw $100,000, you'll net $80,000 from the distribution after the withholding. You may not be comfortable with this and prefer more flexibility in terms of what YOU want to withhold for taxes.
Even if you don't like the traditional Financial Advisor model and rather go the "robo-advisor" route (like Betterment), the IRA still holds a lot of value for those that want absolute control over their assets, whether they "self-direct" or get some help with the investment management.
Regarding taxes, a Traditional IRA rollover is NOT a "taxable" event. It is a "tax-reportable" event. This simply means that it is a transfer of assets from one tax-deferred account to another. As such, no taxes are due as long as you don't physically take control of the money. If there is a rollover check involved, it will be titled "New Financial Institution" FOR THE BENEFIT OF "your name here". You'll receive a Form 1099 from the old plan sponsor that you can provide if any questions come up during tax time.
Some Potential "Cons" to the Traditional IRA Rollover:
There are a couple of things to consider about IRAs. If you're looking to get help with investment management, chances are you will be paying higher costs to a Financial Advisor for that service versus managing the assets yourself.
Also, keep in mind that if you're still receiving "earned income" (i.e salary, wages, tips, etc.) IRAs have substantially lower contribution limits compared to 401(k) accounts.
In 2019, the maximum contribution you can make to an IRA is $6,000 if you're under 50, and $7,000 if you're over 50.
The maximum pre-tax contribution to a 401(k) in 2019 is $19,000 if you're under 50 and $25,000 if you're over 50.
That said, you can "max out" your contributions to a 401(k) and IRA if you have the cash flow to do so.
Option #5: Rolling the funds over into a Roth IRA
First, let's have a word on TAXES. The primary difference between a Traditional IRA and Roth IRA lies in the taxation of the withdrawals.
Assuming the funds in your Traditional IRA are all "pre-tax" (either from a rollover of a pre-tax account like a 401(k) or if you were able to deduct contributions from your income in previous years), any amounts withdrawn are TAXABLE at your marginal income tax bracket rate in the year that you take the distribution.
However, if you play by the rules the right way, withdrawals from a Roth IRA are completely TAX-FREE.
In order to qualify for tax-free withdrawals, the account must be open for AT LEAST 5 YEARS and you must be AT LEAST 59 1/2 YEARS OF AGE.
Here's the main thing to consider when weighing out a Traditional vs Roth IRA: WHEN DO I WANT TO PAY THE TAXES?
The "catch" with Roth IRAs is that you pay the taxes on the FRONT END (when you make the contribution into the account). In other words, the amount that you contribute is INCLUDED in your income for the year.
It's important to know that if you process a rollover from a Pre-Tax account like a Traditional 401(k) into a Roth IRA, the amount that was rolled over is INCLUDED in your income for that year, making it TAXABLE.
So, if you rollover $300,000 from a Pre-Tax 401(k) into a Roth IRA, congratulations, you made $300,000 of income in that year. That's going to be a hefty tax bill.
That being said, if you are adamant about the fact that you will be in a HIGHER tax bracket in retirement, then the rollover into the Roth IRA may make sense while you're in a lower tax bracket.
Similarly, if you're still early on in your career, and you haven't hit your peak earnings years, it may be worth considering.
However, most people in retirement are in the LOWEST tax bracket they've ever been in because they're no longer earning income.
Again, you should take into account your specific tax circumstances, and consult a tax professional before making any financial decisions based off of taxes.
It's worth mentioning that if you are rolling over money from a Roth 401(k) into a Roth IRA, there are no taxes involved. However, keep in mind that newly established Roth IRA account still has to be open for 5 years before qualifying for tax-free withdrawals.
Lastly, keep in mind that if your Adjusted Gross Income is above a certain threshold, you will be "PHASED OUT" from being able to contribute to the Roth IRA, even if you have "earned income".
You should take some careful consideration into what you do with your 401(k). Here are the main things to consider:
-Flexibility of withdrawals
-Tools/Functionalities of other platforms
-Your specific goals, needs and tax situation
If you have questions on any of these options, along with the pros/cons, feel free to send me a DM on IG: @themillennialmoneymentor.