As a young or mid-career professional, you are looking to grow your income and make the most of your finances. So, you may have switched jobs recently. Now you have to navigate all the new benefits. But an essential item to consider is what to do with your old 401(k). Are you trying to figure out what to do with your old 401(k)?
Well, first off, congrats on the new job! It can be daunting to navigate all the benefits with your new employer. And on top of that, you have to figure out what to do with your old 401(k), health savings account, and other portable benefits you earned while working with your previous employer. Moving to a new employer is an excellent opportunity to get your financial house in order. It is usual to put the duller housekeeping items on the back burner. Not considering and taking action with your old 401(k) can result in a less than optimal financial situation.
So, what happens to your old 401(k)? It stays where it is for many people. And having the funds remain in your past employer's plan can be a rational tactic. But, without proactive planning, investors may end up with multiple 401(k) accounts spread across various employers. There may be some benefits of keeping the old plan if the plan offers investments you prefer to keep or use to diversify your total portfolio. But having too many old 401(k) accounts can make record-keeping demanding. It can become challenging to understand your accurate risk exposure and make it more difficult for you to feel in control of your money.
Taking a proactive approach to managing your financial plan is critical. There are several options for you and your old 401(k). Those options are:
Do nothing - keep the 401(k) at your old employer.
Transfer your old 401(k) to your new employer's 401(k) plan.
Roll your old 401(k) to a Traditional IRA.
Roll your old 401(k) to a Roth IRA
Cash it out
The best approach is to understand your options and make the best decision based on your goals, tax status, and financial plan.
The Analysis
Thinking about your 401(k) investments as part of your comprehensive financial plan is critical. Take a careful look at the options offered in each option. With each option, you should investigate:
Investment options
Fees and internal costs
The convenience of consolidating accounts
Risk control of your entire portfolio
Services offered
As you analyze your situation, you should begin to uncover the following considerations. You may decide that you can craft a more diversified portfolio with one strategy. You may find you could replicate your risk strategy in each account. Or you may select different asset classes and funds in each account that creates an appropriate total risk profile. If you hold a target-date fund, you may want to consider a rollover. The two funds may have the same target date, but the risk profile between each fund can differ. It isn't easy to understand what you are holding, so it may be beneficial to roll over the assets and consolidate them into one target-date fund.
Or you may prefer the investments offered in the new plan and choose to simplify your strategy by keeping everything in one place. Or consolidate all your old 401(k)s to an IRA and contribute to your new 401(k). Or where you hold the funds may offer better services. You may find one option caries more fees and internal costs. Your options are numerous. Consider all these factors when making a decision.
Let's take a look at the different options.
Do Nothing
Many employers allow you to leave the plan where it is. However, any unvested assets won't continue on a vesting schedule. Vesting ends with your termination date, so your plan balance will be the amount you've contributed, any vested employer contributions, and any growth in the plan. You may find the old 401(k) offers superior investment options to any other alternative, the lowest fees, and the best options.
Transfer the Old to the New
You may find the new 401(k) has lower fees and better investment options. Or you may want to simplify life by having fewer accounts floating around. If the new plan accepts transfers (review your new plan's documents to see if this is an option), you may be able to move the old funds to your new 401(k). Moving your old 401(k) to your new 401(k) is straightforward. There are two ways you may transfer your funds.
The Direct Transfer
The first is "direct transfer" (also called a direct rollover or trustee to trustee transfer). The direct transfer is the cleanest option. The direct transfer amount you have invested in the old plan rolls over intact, with no taxes deducted, to the new 401(k). The direct transfer option works if the old plan administrator makes the check payable to the new 401(k) administrator or directly transfers the funds to the new administrator.
The Direct Distribution
The second option for moving your 401(k) is the direct distribution (also called an indirect rollover). In this situation, a check is made payable to you. The old plan will withhold 20% of the plan balance for taxes. You then have 60 days to deposit the total amount to the new 401(k). The total amount matches the original ending balance in your old 401(k). Thus, you will be required to pay 20% of the taxes withheld out of pocket. Your tax return will correct for the amount you paid in withheld taxes. You may see this as an opportunity to make a short-term loan to yourself, and there are some circumstances where it might work – but it can be costly from a tax standpoint if executed incorrectly. If you miss the 60-day window and don't contribute the original total amount to your new plan, you'll get hit with penalties if you're under 59 ½ and taxes.
Roll to an IRA
You may find that the old 401(k) carries extra costs you don't want to incur, or the new 401(k) doesn't offer the investment options you wish to have. You may consider rolling the funds to an individual retirement arrangement (or IRA).
If you roll your old 401(k) to an IRA, the same rules apply to a direct transfer and direct distribution. However, one thing to keep in mind and not to get confused about is the IRA one-rollover-per-year rule. The IRA one-rollover-per-year rule stipulates you may only do one direct distribution (the situation where you receive the funds) once a year when moving funds between IRAs. This rule does not impact:
rollovers from traditional IRAs to Roth IRAs (conversions)
trustee to trustee transfers to another IRA
IRA to plan rollovers
plan to IRA rollovers
plan to plan rollovers
Keeping the one-rollover-per-year rule in mind can be critical if you have multiple IRAs and are trying to consolidate your financial situation.
Roll to a Roth IRA - But Be Careful
It may make sense to do a Roth conversion. Pulling money out of your 401(k) to convert it while you are still working doesn't typically make sense because it can create a costly tax burden, so investors usually wait until early retirement. However, an opportunity may exist for tax efficiency if you expect your tax rates to be higher in retirement than currently. You may consider converting pre-tax money in a 401(k) to a Roth IRA. A great example of when this may make sense is if you are taking a year or two away from work and don't expect to have any other income. Multi-year sabbaticals are growing more common among Millennials, and this can pose a tax planning opportunity.
There are income limits on Roth IRA account contributions, but you can convert to a Roth IRA without income limitations. You'll need to pay the taxes you deferred when you contributed to the traditional 401(k) account, plus the growth of the investments will also be taxed. But once you pay the taxes and deposit the funds into the Roth IRA, they grow tax-free, and you will not be subject to required minimum distributions starting at age 72.
Roth IRAs can be a significant advantage for income planning in retirement, as they may help keep you in the lower tax brackets and pass wealth on to the next generation.
You may also find you have a Roth 401(k) and are unhappy with the plan options and costs. If you are unhappy with the old plan, it may be worth investigating rolling the after-tax money from the old 401(k) to a Roth IRA.
Cashing Out Brings Costs
The final option is to cash out the old 401(k). The plan administrator will withhold 20% for taxes, and you'll get hit with a 10% penalty at tax time if you are under age 59 1/2. The extra income may also bump you into a higher tax bracket, resulting in even more taxes due when your file your tax return. Taking money out of your plan may also mean you fall short of retirement goals. Taking this option can be costly and inefficient, but it may be the only option for some folks if they need money.
The Bottom Line
Thinking through a 401(k)-rollover strategy for Millennials and Gen X should be part of their regular financial housekeeping. Your financial plan can guide you during such transitions in life. It ensures you stay organized and helps you stay on your path. There are many options, so investing the time to identify what is right for you makes good sense.
Are you trying to figure out what to do with your 401(k)? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your retirement and begin best optimizing your financial plan in that meeting.
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