5 Things You Can Do With an Old 401(k)
Dear Rich Lifer,
By the end of this year, Americans will have forgotten over $1 trillion in retirement accounts.
Capitalize, a fintech company, recently ran a study that found almost a fifth of all the money American workers have in retirement accounts is tied up in old plans.
The estimated average size of those old accounts is $55,000.
If you’ve recently changed jobs or you’re thinking about making a move, don’t forget about your 401(k) or 403(b) with that employer.
One misstep can cost you thousands of dollars in retirement savings if you’re not careful.
What to Do With an Old 401(k)?
Whether you’re switching jobs or simply have forgotten about an old 401(k) from a previous employer, there are really only five things you can do with an old plan: leave the account where it is, roll the balance into a new or existing IRA or new employer’s plan, make an indirect rollover, or take a cash distribution.
Each of these options comes with pros and cons. Today we’ll dive into each so you know what option is best for you.
- Do Nothing
If you have at least a few thousand dollars in your old 401(k) plan, then most companies will allow you to keep your 401(k) savings in their plans after you leave.
This is typically the default option for most employers since it requires no action. But leaving your 401(k) where it is isn’t always a bad idea. In fact, there are some good reasons not to touch it.
For one, your previous employer’s plan might have investment options your new employer’s plan does not offer. The investment fees might also be significantly lower. And finally, if you’re considering keeping your savings in a 401(k) or rolling it over to an IRA, you might prefer your old 401(k) plan because of the added protection.
Employer-sponsored retirement plans provide broader creditor protection under federal law than most IRAs.
- Roll the Balance Into an IRA
A Rollover IRA is a retirement account that allows you to move money from your former employer-sponsored retirement plan, into an IRA.
Before you open an IRA at your bank or brokerage firm, make sure you research fees and expenses. Some institutions offer better deals than others.
Reasons you should consider moving your retirement savings into a direct rollover IRA include:
- Your money has the chance to continue to grow tax-deferred
- If you’re younger than 59 1/2, you can withdraw money penalty-free for a qualifying first-time home purchase or higher education expenses
- Your money is transferred directly from one retirement account to another. No money is withheld for taxes
- Most IRAs offer a broader range of investment choices than is available in most employer-sponsored 401(k) plans
Some reasons why the Rollover IRA may not be your best choice include:
- After age 72, you’ll have to take annual required minimum distributions (RMDs) from a traditional IRA (but not a Roth IRA) every year, even if you’re still working
- Federal law offers more protection for money in 401(k) plans than in IRAs. However, some states offer certain creditor protection for IRAs too
- Roll the Balance Into Your New Employer’s 401(k)
Another option is to roll your remaining savings into your new employer’s 401(k). This isn’t always possible but it’s worth asking your new employer since it offers a few benefits.
First, your savings will continue to grow tax-deferred. Second, your new employer might have better investment options you can take advantage of with lower fees. And third, having one 401(k) instead of two makes retirement planning that much easier.
As we said, it’s not always possible to roll your old plan into your new employer’s plan but it’s always worth asking.
- Make an Indirect Rollover
Assuming you can’t take advantage of the other three options mentioned, then this next option is your best bet.
How an indirect rollover works is you receive a check for the balance of your old account made payable to you then you have 60 days to complete the rollover process of moving these assets to your new employer’s plan or an IRA.
If you don’t complete the rollover within 60 days, you’ll owe income taxes on the amount you failed to roll over. And if you’re under 59 1/2, you’ll also face a 10% penalty tax.
Another important point is your old employer is required to withhold 20% from your distribution for federal income tax purposes. To avoid being taxed and penalized on this 20%, you have to cover this amount when you make your rollover contribution.
Then, you wait until the following year when you can file your income tax return to receive the withheld amount.
The indirect rollover is not ideal for many people. If you have enough cash on hand to cover the 20% your employer is required to withhold, then this might be a good option for you. Either way, make sure you plan out the timing for this rollover so you’re not caught paying penalties and more tax than you have to.
- Take the Cash Distribution
Your final option is simply to cash out. We left this one until the end because it’s the least desirable option. If you have a small balance in the 401(k), this is sometimes the easiest thing to do.
Or if you’re over 59 1/2 and starting to spend 401(k) money, maybe you’re only working part-time and relying on retirement savings to cover your expenses, then taking a cash withdrawal is a reasonable option.
But if you can avoid cashing out, that’s usually best. The consequences of withdrawing vary depending on your age and tax situation. If you withdraw from your 401(k) before age 59 1/2, the money will generally be subject to both ordinary income taxes and a potential 10% early withdrawal penalty.
There are exceptions to this rule, however, if you stopped working for your former employer in or after the year you reached age 55, but are not yet age 59 1/2. This exception doesn’t apply to assets rolled over to an IRA.
Deciding what to do with an old 401(k) plan can take some serious thought. Consider these five options and find out the rules your new and former employers have before you make any decisions.
Also, consider all fees and investment choices in your new plan. Everyone’s situation is different. The best thing you can do for yourself is not to forget about your old plan or assume it’ll work itself out. Have a plan and you won’t risk losing any of your hard-earned retirement savings.
To a Richer Life,
The Rich Life Roadmap Team