What to Do, and Not Do, With Your Old 401(k)
Leaving your current employer can be a tumultuous time. Either you are sad to go or excited for a new opportunity or hopefully both — but usually what you are not, is thinking about what to do with your existing 401(k) plan. With the New Year upon us and fresh starts all around, now is the time to start cleaning up those old retirement plans, so let’s review the possibilities.
Cash It Out
Most people know this is not a smart move because you not only pay normal income tax on the distribution, but you also incur a 10% penalty for early withdrawals (prior to age 59.5). Plan providers will also automatically withhold 20% for taxes plus the 10% penalty. If that 20% doesn’t cover your full obligation at tax time, you could owe even more. If you are younger than 59.5, cashing it out should be a last resort. (Note: there are exceptions like the “Rule of 55” where if you terminate employment between the ages of 55 and 59.5 and if don’t have other money sitting in a plan of a former employer, you can avoid the 10% penalty. For details, consult a tax professional.)
Leave It Alone
Far too often people change employers and just leave their old 401(k) where it is. It sits stagnant, without the possibility of adding new money to it, most likely invested in the same stale asset allocation as when they left. Some employers have actually started forcing former employees to cash out or rollover their old 401(k)s if their balance is below a certain threshold. Employers have gotten wise to the fact that it is a costly liability for them to let their former employees just sit on these retirement accounts so they are “encouraging” action in order to shift the fiduciary burden elsewhere.
Roll It Over1
A rollover is simply the formal way to transfer money from one retirement plan to another without incurring negative tax consequences or penalties. Typically, rollovers go from an employer-sponsored retirement plan, such as a 401(k), to an IRA. Usually rollovers are only possible after you are no longer working for that company, but there are exceptions. Some employers offer “in-service” rollovers; and of course if you are already age 59.5, you always have the option to take a penalty-free withdrawal. Here are the main rollover options:
- Direct Rollover from old company 401(k) plan to new company retirement plan. The new 401(k) plan sponsor can provide instructions on this process but the benefit is that you consolidate your accounts into one. Forgetting about money left in old plans is not as uncommon as you would assume so consolidation has its own merits.
- Direct Rollover from old company 401(k) plan to an IRA. This method is advantageous because 100% of the money gets transferred from trustee to trustee. This method also gives you the most flexibility. Typically most employer plans have a limited set of investments to choose from for each plan participant. You are typically stuck choosing among a handful of mutual fund managers and using some boilerplate asset allocation questionnaire to try to create the right mix of investments. With an IRA, you have a much greater universe of investment options to work with so if you choose an asset allocation now and it isn’t working down the road, you can go back to the investment pool and choose among many other options. While you absolutely have the opportunity to open an IRA directly with an investment company, like Vanguard, opening an IRA through an advisor gives you access to investment expertise and their ability to monitor the portfolio on your behalf. The combination of more investment options, personalized asset allocation and ongoing monitoring is hard to beat.
- Indirect Rollover – this last option works fine, and is definitely better than a cash out or leaving it alone, but it can get a little hairy. In the indirect method, instead of the money going from one financial institution to another, it gets cashed out of the old company plan and sent directly to you via check. In order to abide by the rollover rules and avoid any costly penalties, you have 60 days to reinvest that money into a qualified plan such as an IRA. The challenge with this method is that the old plan sponsor will withhold 20% of your money for taxes. You will eventually get credit for this 20% when you prepare your taxes but this means two things. First, only 80% of the money gets transferred over and invested right away. Two, unless you add back in the 20% from other sources, the IRS will treat it like a premature distribution and penalize you 10%. Similarly, the other pitfall is if you accidentally slip past the 60 day window before reinvesting, the IRS also treats this like a premature distribution penalizes you accordingly. Ouch.
It’s worth mentioning that one unique benefit of rolling over money to an IRA at CommunityAmerica is the potential for a higher Profit Payout2 . Either way, dealing with an old 401(k) doesn’t have to be complicated if you take the time to understand what you are doing. If you aren’t sure which option is right for you, speak with a financial advisor and see what they suggest. Usually there is no cost for an initial meeting and at least then you will have a professional opinion so you can make an educated decision.
Tim Blake is a CERTIFIED FINANCIAL PLANNER™ with CommunityAmerica Financial Solutions and works primarily out of the 64th Street Branch. To speak with Tim, or another advisor, about your old 401(k) plan or any other financial planning needs, simply click the button below.