If you’re in the process of changing jobs or retiring, you probably have the opportunity to take advantage of a 401(k) rollover (the process of moving your money to a new retirement account). And depending upon what camp you’re in, you will have slightly different options. In this post, I examine both scenarios and explain when a rollover makes sense and how to do it in a way that maximizes your nest egg.
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How to Handle a 401(k) Rollover When Changing Jobs
The average American works about 4.6 years at each job, so you’ll have to figure out what to do with an old employer-sponsored retirement account a few times throughout your career. And when you do, there are four primary ways to handle your 401(k) balance:
- Do nothing — leave your old 401(k) alone.
- Roll over your savings into an employer-sponsored 401(k) at your new job.
- Roll over your savings into an IRA, which isn’t employer-sponsored.
- Withdraw or “cash out” your money.
I take a closer look at each option below. But before I do, you should note that if your 401(k) has a small balance, you’ll need to be proactive and let your old employer know what you want to do, or it may be able to make that choice for you. That’s because if you don’t say otherwise, your employer can automatically cash out any amount under $1,000, or roll it over into an IRA if your balance is between $1,000 and $5,000.
Option 1: Leave Your 401(k) Alone
One of your options is to do nothing, and and leave your money in the old 401(k). This is certainly the path of least resistance, but it’s not always the best option.
Leaving your money in your old 401(k) might make sense if your current plan has low fees and a lot of great investment options. (This is more likely the case with very large employers; otherwise, IRAs typically offer more choices and lower fees than 401(k)s.) However, one of the main arguments against leaving your money in an old account is that it can be seriously inconvenient.
If you switch jobs a few times and never move your money from your old 401(k)s, you’ll have to keep track of statements from several different providers. And if you move to relocate for said new job, you’ll have to notify each provider with your new address. Some plans also charge hefty penalty fees for non-employees who leave their money, which you definitely want to avoid. (The best way to determine potential non-employment fees is to reach out to your provider directly.)
Option 2: Roll Your Money Into a new 401(k)
Your next option is to roll over your old 401(k) into a new 401(k) — as long as your new employer offers one and accepts rollover contributions, of course. Let’s look at some of the pros and cons in this situation:
- All your money is in one place. This is perhaps the biggest advantage to rolling over your 401(k) into a new company plan because it makes it far easier to manage your money.
- 401(k)s have more generous contribution limits than IRAs. You can contribute a lot more annually to your 401(k) than an IRA. In 2016, you can contribute $18,000 annually to an employee-sponsored 401(k), versus only $5,500 to an IRA (or $6,500 if you’re over 50).
- Potential employer match. If your employer matches any part of 401(k) contributions, you should take advantage of that opportunity. Some employers match the amount you contribute dollar-for-dollar until you reach a certain cap, usually a percentage of your salary. Others might match a percentage of your contributions (half is pretty common) until you reach a certain cap. Either way, it’s an incredibly benefit to have.
- You can borrow from your 401(k). While it’s usually not advisable to borrow from your 401(k), it’s possible if you’re desperate and out of other options. That isn’t the case with IRAs, except in very specific circumstances, such as paying for college. Remember: The money you borrow will no longer be growing, and you may not be allowed to contribute any more until you repay your loan.
As far as cons go, there are two you worth your consideration: poor flexibility and waiting periods. By far, the biggest downside to sticking with a 401(k) over an IRA is the lack of flexibility. You may not like the provider your employer is using or the investment options it offers, and you’ll likely pay more in fees than with an IRA.
Some employers (nearly one third of all employers, to be exact) also have a waiting period before you can start participating in a new 401(k) plan. This period can last anywhere from six months to a year, and that’s a pretty long time to be in retirement limbo. Compare that to an IRA, which allows you to start contributing immediately.
Option 3: Roll Your 401(k) Into an IRA
Rolling over an old 401(k) into an IRA is a compelling option for many people who are transitioning into a new job — especially if the new employer does not offer a 401(k) plan. Here’s why:
- IRAs are available for everyone. Maybe you’re a freelancer, or maybe you’re joining a small business without a 401(k) option. Whatever your situation, an IRA is available even when a 401(k) is off the table, and you won’t lose time with a waiting period.
- More investment options. While there are certainly exceptions to this rule, IRAs often beat 401(k)s by offering a wider variety of investment options, meaning you get much more control over how you’ll invest your money.
- Lower fees. IRAs usually have lower fees (many have no fees), while 401(k)s average 1% to 2% of your plan’s assets. That might not sound like a lot, but if you have a significant sum in your account, it adds up quickly. Think about it: Paying 2% in fees on a $100,000 401(k) balance amounts to $2,000 a year.
As for cons, IRAs have much lower contribution limits than 401(k)s and you can’t borrow against them. (Borrowing against a 4019(k) is never a good idea, but it’s an option you won’t have with an IRA.)
Option 4: Withdraw Your Money
Perhaps you need extra money to pay off some bills or make a significant purchase. Why not just take the money out of that 401(k)? Let me be clear: That is almost never a good idea.
In most cases, you will get walloped with a 10% early withdrawal penalty if you cash out your 401(k) before the age of 59½ (or 55 in certain cases, which I discuss later). Second, you will have to pay income tax on that money. Finally, you’ll lose an untold amount in interest and investment gains that you would have earned by either keeping the money in your old 401(k) or by rolling it over into a new retirement account.
Let’s look at an example I hashed out using this retirement calculator. Imagine that you’re 35, and you want to retire at 65. You have a 401(k) with $30,000 in it.
If you cashed out that balance, you would immediately lose $3,000 to the early withdrawal penalty. But you would also have to pay federal and state income taxes on the entire sum. (By waiting until retirement to withdraw the funds, you’d only pay taxes on what you took out each year, and do so in a presumably lower tax bracket.) Assuming a federal income tax rate of 20% and a state income tax rate of 6%, you’d be left with just $19,200 of your $30,000.
Getting back 64 cents on the dollar is hardly the worst of it though. Assuming a 7% rate of return, that $30,000 could grow to more than $228,000 by the time you retire at age 65.
Cashing out your 401(k) early sabotages your long-term retirement savings, which could amount to hundreds of thousands of dollars in investment gains and interest. That’s why cashing out is almost never a good idea.
How to Handle a 401(k) Rollover When Retiring
When you retire, you won’t have the option to roll your money into a new 401(k). That leaves you with three options: do nothing, roll it over into an IRA, or withdraw your money.
Option 1: Leave Your 401(k) Alone
If you’re retiring and are younger than 70½ (the age when you are required to start taking distributions from your 401(k)), you have the option of doing nothing and letting your money continue to grow in your old 401(k). This could make sense if you like your plan’s investment choices and find the fees reasonable.
Another reason for retirees to consider staying put is that 401(k)s have the “rule of 55.” This rule says that if you leave the employer with whom your 401(k) is established the year you turn 55 or older, you can start withdrawing money from your account penalty-free. This isn’t the case with an IRA, which will force you to wait until you’re 59½ to avoid a penalty.
It’s also important to mention that you can’t borrow from your 401(k) and pay it back once you’ve left the company where your 401(k) is established. You’ll also want to make sure you won’t have fewer investment choices or higher fees once you’re no longer an employee. And if you really want to exercise the maximum control over your how your money is invested, a 401(k) may not cut it — in that case, an IRA is probably the way to go.
Option 2: Roll Your 401(k) Into an IRA
The main advantages of putting your money into an IRA are flexibility and control. You will typically have a lot more investment choices, and you’ll get to decide exactly how to allocate your own money. You may also pay less in fees, and an IRA can be handy for consolidating your money if you happen to have several 401(k)s.
Remember that you can’t tap your IRA before 59½ without paying a steep penalty, except in the case of certain expenses such as college.
However, you can elect to take Substantially Equal Periodic Payments, also called SEPP or 72(t) payments. These payments are based on how old you are and how much you have in your IRA, but can be calculated three different ways. The major catch with SEPP is that you must take payments for five years or until you’re 59½ — whichever period is longer — otherwise you will face penalties. The payments are also fixed, so you can’t change how much you’re getting after beginning SEPP.
Option 3: Withdraw Your Money
The consequences of cashing out are less dire at typical retirement age. Assuming you’re over 55 and retiring from the company where you have your 401(k), you can take out the money, or “cash out,” without an early-withdrawal penalty. (If that’s not the case, you’ll have to wait until 59½.)
However, you will still have to pay income tax on the entire balance at once — which could push you into a higher tax bracket, penalizing you further. Not to mention that you will lose out on any additional interest or investment gains your money would earn if you let it stay put for longer.
How to Roll Your 401(k) Into an IRA
If you’ve decided to roll over your money into an IRA, you’ll need address two very important questions: What kind of IRA do you want, and where do you want to open it?
You’ll first need to decide whether you want to open a traditional IRA or a Roth IRA. (While there are technically several other types of IRAs, most only apply in special circumstances.) Both traditional IRAs and Roth IRAs allow the same level of contributions: $5,500 per year, or $6,500 per year if you’re 50 or older.
Traditional IRAs vs. Roth IRAs
Here’s what you need to know about Traditional IRAs and Roth IRAs:
|Factors||Traditional IRAs||Roth IRAs|
|Taxes||As long as you meet certain criteria, the money you put into a traditional IRA isn’t subject to income tax until you actually withdraw it. Note that when you do withdraw your money, you will also be paying income tax on the interest and investment gains your money has earned.||Unlike with a traditional IRA, you have to pay income tax upfront on the money you put into a Roth IRA. However, when you withdraw the money, you won’t have to pay taxes on it, or on any interest or investment gains it has earned.|
|Cutoff Age||You can contribute only until age 70½.||You can contribute at any age.|
|Eligibility||You are eligible regardless of your income.||If you make too much money, you might not be eligible to contribute to a Roth IRA, or may only be eligible to contribute a reduced amount. For instance, if you’re a single filer, your modified adjusted gross income has to be under $116,000 to contribute the maximum allowed, and under $131,000 to be eligible for any sort of contributions whatsoever.|
|Early Withdrawals||You cannot withdraw any portion of a traditional IRA before age 59½ without an early-withdrawal penalty unless certain exceptions apply.||You can withdraw your contributions, but not the earnings on those contributions, before age 59½ without an early-withdrawal penalty. You can withdraw earnings penalty- and tax-free for a down payment on a house (up to $10,000) or to pay for college. (Note that even if you’re 59½ or older, you must have made contributions to the Roth IRA for at least five years to withdraw earnings tax- and penalty-free.)|
Obviously, you are the only one who can determine whether a traditional or Roth IRA will be best for your specific situation. However, here are a couple of general rules to follow:
- If you’re starting your IRA later in life or want to reduce your taxable income each year, a traditional IRA may be the way to go.
- If you’re younger and don’t have a big income, or want a bit more penalty-free flexibility when it comes to withdrawing your funds, a Roth might be the best choice.
Now that you’ve decided which type of IRA is best for you, you’ll need to decide where to open it. Banks, brokerages, and just about any other large financial institution will offer IRAs. Most will offer a variety of investment options — the main differences will be the amount of investment guidance you get and the fees you pay.
Fortunately, The Simple Dollar has already done the legwork for you to find some of the best IRA accounts. Our guide profiles four of the best online brokers out there. Some are more suited to novice investors, while others are ideal for more seasoned traders. All are great places to manage your nest egg.
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After you’ve opened an IRA with a solid provider, contact your former employer to see what information they need to move your funds. Be sure to request a direct rollover — this way, your money goes directly from your old account to the new one. If this doesn’t happen and you receive a check, you have 60 days to get that money into your new IRA. Otherwise, you will have to pay income tax on the money, plus an early-withdrawal penalty if you’re not 59½ or older.
Tips for Rolling Over Into a New 401(k)
If you’ve decided to rollover your 401(k), you have two options: You can rollover into a new 401(k) or an IRA. Here are four practical tips to help you make the best decision possible.
- Double-check to make sure your new employer’s 401(k) allows rollover contributions. If they don’t, you will either have to leave your money sitting in your old 401(k) or open an IRA.
- See whether there is a waiting period before you can participate in the new 401(k). If so, you can leave your money in your old 401(k) during that time or put it in a conduit or rollover IRA, which basically acts as a holding account until you’re able to participate in the new 401(k).
- Request all the necessary paperwork for a rollover from your old and new employers. This should include distribution forms from your old employer and may also include verification forms that your new employer needs your former employer to complete.
- Make sure to ask for a direct transfer of funds from your old account to the new one. If your old employer instead gives you a check for your 401(k) balance, you will have to pay income tax on that amount — a very expensive mistake.
Retirement in 2016: A new Fiduciary Standard
Financial advice from trained professionals is a big part of making the most of your investment. That’s why it’s important to understand exactly what you can expect from them.
This might be a shocker for some, but financial advisers are not legally required to put your interests above their own — not yet, anyway. Come April 2017, the Department of Labor will begin to enforce its new fiduciary standard that requires advisers to offer guidance for retirements accounts (IRAs, 401(k) plan assets, and other qualified monies saved for retirement) that is strictly in the best interest of clients.
Enforcing such legislation is complicated, and for the nation’s $25 trillion financial advice industry it means a serious overhaul of operations and procedures. (One example is that advisers will be required to disclose conflicts of interest and fees to clients.) Liz Skinner from InvestmentNews even went so far to state that these changes will “fundamentally shift the advice landscape.”
But what does the new standard mean for you and your 401(k)? Practically speaking, it should mean that you will get better, more transparent advice from your financial adviser in the future. And in turn, you get more control over your assets. Hopes are high that this ruling is a big win for clients, and there’s no doubt it represents a positive change for the industry.
Grow Your Nest Egg — and Stay Organized — With a 401(k) Rollover
Whether you’ve decided on a rollover into an IRA or another 401(k), congratulations are in order: First, your money should continue to grow, increasing the chances that you’ll have enough saved when it’s time to retire. Second, you’ll be able to keep better tabs on your nest egg when it’s in one place.
The time may come when you want to diversify your savings, however. That can be a smart strategy if you do it purposefully. Experts recommend dividing your money between a tax-deferred account, such as a 401(k) or a traditional IRA, and a Roth IRA that requires you to pay tax on contributions upfront but then allows your money to grow tax-free. Since it’s hard to say what tax bracket you’ll end up in when you retire, having both accounts can help cushion you no matter what happens.
If you’ll be opening a new IRA, remember to check out our guide to the best IRA accounts for some expert guidance and a more in-depth discussion of Roth IRAs versus traditional IRAs.
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