Our featured article of the month, Leaving a Job? Consider These Options for You 401(k), provides the steps you can take when handling your 401k with your former employer. While the steps seem rather straightforward, inevitably investors make mistakes and/or do not consider all of the pros and cons regarding their options.
Cashing out the plan balance is not usually common when the 401k balance exceeds a certain amount, but some investors, unintnetionally or not, consider this option without understanding the full effects of their decision. A 20% tax withholding may not seem that bad at first, however the amount withdrawn will be added to your current income for that year, possibly increasing your tax obligation in excess of the required withholding amount. Additionally, calculations are seldom done on the future value of those funds inside the plan versus outside the plan, minus the taxes and the tax deferred status. Over time, those figures can amount to a tidy sum.
Leaving your 401k with your former employer is usually not the wisest decision either. Former employers have less incentive to continue to service your account than those of current employees. While that may seem far fetched, it is something I have run into in the past. Additionally, remembering to manage the investments and staying on top of the changes within the plan become less of a priority compared to your new employer plan.
As for transferring and rolling over funds, each decision affords various pros and cons that, dependant upon your financial situation, should be carefully considered. While it is accurate that most 401ks offer the bare bones regarding investment choices and IRAs can offer almost every investable investment vehicle available, the structure of the 401k plan alllows for benefits not available in IRAs. Therefore, you should once again carefully consider your personal situation and determine whether the benefits offered through the plan are useful to your situation.
The Great Resignation
Job-hopping has increasingly become a trend in recent years. The so-called “Great Resignation” that was precipitated by the Covid-19 pandemic has led an unprecedented number of employees to leave their jobs in search of greener pastures. Despite threats of a possible recession on the horizon, workers continue to switch jobs at a record pace. If you’re someone who’s considering a professional change, be careful not to lose track of your old 401(k).
If you’re in the process of changing jobs, dealing with your previous employer’s 401(k) likely isn’t high on your priority list. Between migrating work materials, acquainting yourself with new colleagues, and adjusting to a new routine, certain details like your old 401(k) might slip your mind—but you mustn’t neglect it. The last thing you want is for your hard-earned money to get lost before you circle back for it years later.
With this in mind, here’s a refresher on how 401(k)s work and a discussion regarding the options you have for handling accounts from previous employers.
Recapping how 401(k)s work
A 401(k) is a type of company-sponsored retirement plan that exists to encourage employees to save for their retirements by providing them with exclusive benefits. These benefits come in the form of unique tax treatments that make it easier for workers to contribute and grow their funds over time. Contributions can be made with pre-tax or post-tax dollars and can be invested in securities like stocks, bonds, ETFs, and mutual funds. These contributions are allowed to appreciate within the account without being subject to income and capital gains taxes. The contents of these accounts are generally “locked up” until the owner reaches retirement age, at which point they can start taking withdrawals without incurring early withdrawal penalties.
Different kinds of 401(k) accounts exist, the most relevant of which are the traditional 401(k) and the Roth 401(k). Depending on your individual circumstances, you can choose to invest in either of them or both at once. The decision between the two comes down to whether you’d prefer to pay your taxes upfront or upon withdrawal.
Traditional 401(k)
A traditional 401(k) is a tax-deferred account, which means that it’s funded with pre-tax contributions. These contributions grow tax-free for as long as they remain within the account, but you’ll be responsible for paying income taxes on any withdrawals you make. Traditional 401(k)s essentially allow you to lower your tax burden today in exchange for paying it many years down the line. One of the benefits of making pre-tax contributions is that they can reduce your total taxable income, potentially dropping you into a lower tax bracket. For instance, if you make $60,000 before taxes and opt to contribute $20,500 to your account (the annual contribution limit), your taxable income for the year would only be $39,500.
Roth 401(k)
Roth 401(k)s are funded with post-tax dollars, so you’re fulfilling your tax obligation now as opposed to later. Unlike non-Roth retirement accounts, once the funds are in the account, they’re afforded tax-free growth that you never have to pay income taxes on—assuming you wait until retirement age to start taking distributions. While Roth contributions don’t serve the purpose of lowering your taxable income, they unlock the potential for you to earn tax-free money in retirement. This makes them a particularly attractive option for people who want to avoid the headache of paying taxes in the future or expect their income tax rate to be higher in retirement than it is today.
What should you do with your 401(k)?
The prospect of shifting your 401(k) likely isn’t top-of-mind if you’re in the midst of a career transition, but it’s important to wrap your head around your options sooner rather than later. This is because the average individual transitions to a new job 12 times in their lifetime, suggesting that when it comes to managing your 401(k), it’s not a matter of if you’ll have to, but when. When you leave a job—whether you’ve switched jobs, quit, or gotten laid off—it’s up to you to determine the best path for your 401(k).
Stick with your previous employer
If you’re able to, leaving your 401(k) with your previous employer can be a tempting option. Doing so might make sense for you if the account manager charges minimal fees and has been delivering strong investment performance, or if you simply have too much money in the account to efficiently redeploy it. Additionally, if your previous employer offered 401(k) contribution matching, you may want to ensure that you’ve fulfilled the vesting requirement (if one exists) so that you get access to the full match. Finally, if you own highly-appreciative company stock within your old 401(k), keeping that equity in the account could be more tax-efficient than transferring it to a new one. Be sure to collect this information from your plan administrator before making any decisions.
With all of this in mind, leaving funds in an old 401(k) usually isn’t ideal in the long run. You won’t be able to further contribute to the account, but you’ll still need to keep track of it and continue monitoring the investments within it. This is often easier said than done, as it’s estimated that upwards of $1.35 trillion is currently tied up in forgotten retirement accounts. There’s also the possibility that your former company ceases to exist, which poses a risk to your savings.
Transfer to your new 401(k) plan
If you’re interested in consolidating your funds, transferring the contents of your 401(k) to your new employer’s plan could be the best option for you. This would cut down on the total number of accounts you have, making it easier for you to keep track of them. Your new employer may provide a superior plan with minimal fees and better access to investments that align with your needs, thus rendering your previous employer’s plan obsolete.
After you’ve set up your new 401(k) plan, the process of rolling the funds over from your old account is fairly straightforward. There are two methods for doing this: direct rollover and indirect rollover. A direct rollover is a custodian-to-custodian transaction wherein your old plan administrator simply transfers the balance of your old account to your new one. Since this isn’t technically a withdrawal, you’re exempt from paying income taxes on this transfer. Indirect transfers, on the other hand, involve receiving the funds within your old account in the form of a check. These funds must be deposited into a new retirement account within 60 days to avoid contending with income taxes and an additional penalty.
Rollover to an IRA
You’re also able to transfer the contents of your old 401(k) to a traditional or Roth IRA. Doing so typically delivers more control, investment options, and lower management and administrative costs. If you felt that your previous 401(k) investment options were restricting you, you may enjoy the flexibility of an IRA. You can roll your traditional or Roth 401(k) into a traditional IRA within 60 days without incurring any additional taxes or penalties. If you wish to roll over non-Roth funds into a Roth IRA, you’ll be required to pay income taxes on these funds. On the bright side, you could appreciate not having to pay taxes on your Roth withdrawals after you retire.
Start taking distributions or cash it out
Of all the options available to you, cashing out your old 401(k) may be the simplest but it’s also the most costly. You can choose to withdraw your funds all at once, in the form of a lump sum, or in smaller increments. If you decide to go this route, you’ll have to pay income taxes on whatever distributions you make in addition to a 10% early withdrawal penalty if you’re under 59½ years old. Cashing out the balance of your 401(k) also means that you’ll ultimately have fewer dollars benefiting from the exclusive tax treatments of a retirement account. Since retirement contributions are capped annually, it can be difficult to get money back into a retirement account once you’ve taken it out. Unless you have an urgent cash need, this likely isn’t the strongest course of action.
Closing thoughts
You’re likely to change jobs at least once—if not several times—over the course of your working life, so it’s important that you understand what options you have in regards to your 401(k). Whether you’ve quit, changed jobs, or been laid off, you’re going to have a lot to manage during the transition, and having a plan in place for your 401(k) can help keep your retirement plans on track.
If you’d like help deciding what to do with your 401(k) in the wake of a career transition, contact a certified financial planner professional today.
This material was prepared for DRS and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
References
Elkins, Kathleen. “63 percent of Americans are confused about 401k retirement plans.”
CNBC, 7 March 2019,
https://www.cnbc.com/2019/03/07/63-percent-of-americans-are-confused-about-401k-retirement-plans.html. Accessed 18 July 2022.
Kolmar, Chris. “Average Number of Jobs in a Lifetime [2022]: All Statistics – Zippia.”
Zippia.com, 5 April 2022, https://www.zippia.com/advice/average-number-jobs-in-lifetime/. Accessed 18 July 2022.
“What happens to your 401(k) when you change jobs?” Ameriprise Financial,
https://www.ameriprise.com/financial-goals-priorities/retirement/what-to-do-with-your-401k-plan-when-you-change-jobs. Accessed 18 July 2022.