One of the most common questions we get from members of the public is, “What should I do with my old 401k?”
If you’re leaving (or have left) an old employer, and have a 401a, 401k, 403b, 457, SEP or SIMPLE IRA account from your previous job, you have three basic options available to you: leave it where it is, cash it out, or “roll it over” to another retirement account.
There are definite pros and cons to those three basic options, and important factors to consider for each one.
Although every situation is unique, and you are best served by talking with an advisor and your tax professional before you make a final decision, let’s review your options in general terms:
First Option: Leave it where it is
Most employer plans allow you to simply leave the balance in your account in the old plan, but some do not. An employer who sponsors a retirement plan for their employees has certain specific legal responsibilities to the plan and to your account (called fiduciary duties). Some of those responsibilities include doing their best to make sure you are obtaining good financial advice and are properly invested for your age and risk tolerance, which is impossible to do for former employees who will never again be at a benefits meeting.
Plus, because of the push from state and federal regulators for more fiduciary responsibilities on employers in recent years, we are starting to see an uptick in the number of employer plans who ask their departing employees to take their retirement accounts with them.
If you can leave it in the old plan, and choose to, consider:
- You can not contribute to this account ever again.
- Your investment options will be forever limited to those the employer approves. Whereas there are tens of thousands of available investment options for an IRA account, a typical 401k or 403b account may have only a few dozen to choose from.
- If the plan’s costs are paid for by the participants (which is an option the employer can choose when they set the plan up), your account will be hit with recordkeeping, third-party administration and financial advisor fees in addition to any fees from the investment funds themselves.
For these reasons, we generally don’t advise our clients to leave old accounts with their former employer.
So what are your two other basic options? You can cash out the account, or you can “roll it over”.
Second Option: Cash it out
This is possibly the worst option of the three in most cases, because of the potentially significant taxes you will pay in doing so.
Unless you contributed after-tax money to your account (this is called a ROTH contribution), the money you added to your employer retirement plan was deducted from your taxable income in the years you made the contributions. This lowered your taxable income for the year, which is one of the biggest perks of saving money for retirement using a retirement account or employer-sponsored retirement plan.
The idea is, you receive a tax break now to save for future needs. The money is essentially removed from your income before your income is taxed. Also, while the money remains sheltered in the retirement account, it grows tax-deferred. This offers a much greater opportunity for long-term gains over accounts that are taxed as profits and interest are earned. (If you are taxed 20% on capital gains and interest in a standard brokerage account, let’s say, the difference over 20 or 30 years may be many tens or even hundreds of thousands of dollars more by saving in a retirement account.)
Once you retire and begin to use the money to offset your expenses in your later years, the money coming back out of your retirement account is included as income, and you pay income tax on it, hopefully at much lower tax rates than what you would have paid during your working years.
(We should note that ROTH contributions are already taxed when they go into the account, and become tax-free when you retire.)
Cashing out your retirement plan will add all of that money to your income in the tax year you withdraw your retirement funds. This may push you into a higher tax bracket – possibly a MUCH higher tax bracket – for all of the money you earned the whole year, plus the money you withdraw from your retirement account.
In addition, unless you have a qualifying reason (such as proven hardship, extremely high medical bills, etc.) or are at least 59 1/2 years old when you cash out your retirement account, you will also be hit with an additional 10% tax penalty on the entire balance withdrawn.
Even if you have ROTH contributions in your employer plan, the earnings and interest on your contributions will be taxed and penalized for early withdrawal.
There are ways to do partial withdrawals that can minimize these disastrous effects, but you’ll need the help of a financial planner and your tax pro to work out those details. If you have questions on this option especially, please reach out to us for a free 15-minute phone call to get all of the details you need before making this choice.
Third Option: Roll it over
Generally, we advise our clients to exercise this option when they have a balance from an old company plan that needs to be dealt with.
Doing a “rollover” simply means moving your funds from your old retirement plan account into another retirement plan account (either a personal account or your new employer’s plan).
Rollovers are generally the best option because done properly, there is no tax consequence to you and the entire balance will move from one tax-sheltered account into another one.
We should caution you here, however: rollovers are one of the biggest sources of income for most financial advisors and insurance agents. Even at nVest Advisors, where we are legal fiduciaries for all of our clients and offer many different ways to work with us and pay for our services, many of our investment clients have started their accounts with rollovers from old company plans.
Be VERY skeptical of any advisor or agent pushing you to roll over funds into an account or annuity – you may pay up to 10% in commissions in some of the worst products out there, and be locked into long “surrender” periods before you can access those funds. Also, be sure to know – in real dollars – what your initial and annual fees are going to be before you sign or agree to anything. Any advisor or agent not willing to put their commissions and your fees in writing for you should be immediately disqualified.
If you’ve decided a rollover is the right option for you, you have three additional choices to pick from: do you roll it DIRECTLY over into a personal retirement account (IRA or ROTH IRA), roll it over into your new employer plan, or do what is called an INDIRECT rollover?
We’ve created a handy Rollover Guide to help you decide what is the best option for you, how to make sure your rollover is done properly (regardless of which one you choose), and give you a heads-up on six potential pitfalls you may experience while conducting a rollover.