It’s a question that comes up often – what should I do with my old 401(k)?
There is no one-size-fits-all answer, and responses provided by financial advisors are increasingly scrutinized due to the Department of Labor’s (DOL) fiduciary rule. Fiduciary Benefits Group, which has been a fiduciary since its inception, continues to believe that the best approach is to present options to our clients and let them decide.
The four options are:
- Leave the money in your existing 401(k),
- Roll your 401(k) into your current employer’s plan,
- Roll your 401(k) into an IRA/Roth IRA, or
- Distribute the cash.
Before detailing each, it’s important to clarify that 401(k)s and traditional IRAs share the same tax characteristics. Both are tax-deferred, which means that dollars within these accounts are not subject to income tax until they are withdrawn. A transfer between two tax-deferred accounts is not a taxable event. Similarly, Roth 401(k)s and Roth IRAs are both tax-exempt, meaning that funds within these accounts are never subject to income tax. When transferring funds between retirement accounts, it is vital to maintain the tax status of the account – otherwise you could end up paying tax twice!
Leave the Money in Your Existing 401(k)
Most 401(k)s will allow previous participants to keep their existing balance in the plan. The larger the company plan becomes, the greater their leverage is with the plan custodian. One way for a plan to grow is to permit ex-employees to remain in the plan.
However, leaving funds in an old plan for an extended period can lead to mismanagement, complacency, infrequent rebalancing, and potentially increased administrative fees. If you have multiple jobs over the course of your career, you wind up accumulating just as many retirement accounts, making it difficult to strategically allocate your investment portfolio and easier to alienate previous accounts. For that reason, we rarely recommend clients maintain balances in prior 401(k)s.
Roll Over the 401(k) into Your Current Employer’s Plan
If your new job offers a 401(k), rolling your vested balance into your new 401(k) may be a good choice. It allows you to consolidate your retirement plans into a single account, making it easier to manage and review performance, allocation, etc.
There are some unique tax benefits with having your retirement funds in your current 401(k):
- Investors who are 73 or over do not need to take required minimum distributions (RMDs) from an active 401(k). They would have to take an RMD from an old 401(k) and/or an IRA. Note that if they own more than 5% of the company that they work for, an RMD is required regardless.
- Additionally, 401(k)s are not included in the IRA Aggregation Rule pertaining to backdoor Roth IRA contributions, which is a useful saving technique for high income earners.
Before proceeding with a transfer into your current 401(k), you must verify that the plan accepts rollover contributions. If your 401(k) does accept rollovers, the next step is to evaluate the investment options and fees within the plan. Employer retirement plans are required to offer a broad range of diversified investments to participants. However, there is a chance that the investments have high fees or don’t fit your criteria. Investors also need to evaluate the administrative costs that participants pay, which vary per plan (although some employers choose to cover these fees).
Roll Over the 401(k) into an IRA
The most common course of action for investors is to transfer their previous 401(k)s into a Rollover IRA and/or Roth IRA for a few reasons:
- IRAs are easy to open and widely available.
- They allow investors to continually consolidate employer retirement accounts over time.
- IRAs can be self-managed or professionally managed.
- They provide access to a significantly wider array of investment options.
The last point is an important one, because if you determine that the options in your 401(k) are lackluster, IRAs give you the ability to purchase low-cost index funds, best-in-class actively managed funds, individual stocks, qualified annuities, etc.
However, there are also disadvantages to rolling funds into an IRA:
- You are required to start withdrawing a percentage of funds from your IRAs at your full retirement age.
- A backdoor Roth IRA contribution will likely create a tax liability.
- 401(k)s typically have greater creditor protection.
- It’s also worth noting that if you have your IRA professionally managed, you will likely pay an advisory fee.
Take the Cash
Without a doubt, this is the least advisable option. Funds withdrawn from a traditional (non-Roth) 401(k) are always subject to ordinary income tax. If the amount withdrawn is significant, you could be inadvertently bumped into a higher tax bracket. Additionally, if you are younger than 59 ½, you will be subject to an early withdrawal penalty of 10% on top of income taxes – an exception being if you stopped working in or after the year you reached age 55. The bottom line – don’t do this!
There are several factors to consider when deciding what to do with an old 401(k). A good advisor will help you evaluate the pros and cons of each option to make the best decision for you.
