If you are like most Americans, you are going to work at quite a few different jobs in your career. In fact, Americans born between 1957 and 1964 had an average of 11.7 different jobs between the ages of 18 and 48, according to the Bureau of Labor Statistics. This means there is a good chance that you may have participated in several different employer-sponsored retirement plans by the time you retire.
So what should you do with the assets you’ve accumulated in a 401(k) plan when you leave the company, either to take a new job or to retire? What you choose to do with those assets can have a big impact on your quality of life during your retirement years, so it is important to understand your options.
KNOW YOUR OPTIONS
In deciding what to do with your 401(k) plan, you essentially have four options. (In general, these options also apply to 403(b) plans, for employees of public schools or certain tax-exempt groups, and 457(b) plans, for employees of state or local governments or governmental agencies.) Let’s look at the “pros” and “cons” of these choices:
Option 1: Cash out your 401(k): This involves receiving a check (or “lump-sum distribution”) for the assets in your account.
* You will get immediate access to your money, with little paperwork and without the need for any approvals.
* Your employer will withhold 20% of your money, and this amount will be taxed as ordinary income if you don’t move it to a qualified retirement account (such as a new 401(k) or an IRA) within 60 days.
* The remainder of your withdrawal will also be taxed as ordinary income, and if you’re under age 59 ½, you may incur a 10% penalty.
* Your money will no longer grow tax-deferred.
Option 2: Leave your money in your former employer’s 401(k): You might be able to keep your 401(k) assets with your old employer, although not all companies allow this option.
* Your money can continue to grow tax-deferred in the same investments you had previously chosen.
* Down the road, you can decide to move your 401(k) assets to an IRA or a new employer’s 401(k), if the new employer accepts rollovers.
* 401(k) assets are typically protected from claims by creditors.
* You can’t contribute any new funds to this account.
* You probably won’t be able to take out a loan from your old 401(k).
* You will have fewer investment options than you would if you rolled over your funds to an IRA.
Option 3: Move your 401(k) assets to a new employer’s plan: You may be able to roll over your old 401(k) plan’s assets to your new employer’s plan. Not all employers accept such rollovers, however, so you’ll need to check with your company’s human resources team.
* Your money can continue to grow on a tax-deferred basis in the new employer’s 401(k).
* You will likely find it easier to track and manage your 401(k) assets when they’re consolidated into one account.
* You can delay taking required minimum distributions (RMDs) from your 401(k) if you’re still working after you turn 70 ½.
* 401(k) assets are typically protected from claims by creditors.
* Your new 401(k) may have fewer investment options – or less attractive ones – than your old plan.
* Your new plan could have higher fees and expenses than your old plan.
Option 4: Roll your 401(k) assets into an IRA: You can roll over your 401(k) funds into an Individual Retirement Account (IRA) in one of two ways. By choosing a direct IRA rollover, your funds are sent straight from your 401(k) into an IRA – you never touch the money. Alternatively, you could select an indirect rollover, in which the money comes to you, minus the 20% withheld by your employer. You then have 60 days to move the money into an IRA and avoid taxes and early withdrawal penalties, but you’ll have to cover the 20% yourself, so you might need a substantial amount of cash on hand. You will get the 20% back when you file your tax return.
Regardless of the method, it is important to consider the pros and cons of an IRA rollover:
* You can invest the money in virtually any type of asset allowed by the IRA; you won’t be limited to the options offered by the 401(k) plan.
* You can consolidate multiple 401(k) plans into one IRA, which could make it easier to manage your assets and gain a holistic view of your overall asset allocation and performance
* You may be able to simplify the process of calculating and paying RMDs. If you keep money in two or more 401(k)s, you would need to calculate each RMD separately and then withdraw an RMD from each 401(k). If you own multiple IRAs, you still need to calculate an RMD for each account you own, but you can take the total from just one IRA.
* Your money can continue to grow tax-deferred.
* You can use some of the money for educational expenses, such as tuition or training for a new career opportunity, without having to pay the early withdrawal penalty.
* You can’t borrow against an IRA.
* Your IRA assets are typically only protected from creditors in case of bankruptcy.
* You likely will need to pay management fees to the financial services provider that administers your IRA.
Keep in mind that in the above rollover example, the IRA is a “traditional” IRA. But under some circumstances, you may be able to roll over your 401(k) funds into a Roth IRA, which provides tax-free growth of earnings, provided you’ve had your account at least five years and you don’t start taking withdrawals until 59 ½. Plus, if you own a Roth IRA, you are not subject to RMDs – you can essentially keep your Roth IRA intact for as long as you like. And transferring funds from a 401(k) might be your only entrance to a Roth IRA, which imposes income limits on contributors.
To qualify for the tax free penalty free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 1/2 or due to death, disability, or a first time home purchase (up to $10,000 lifetime maximum). Before taking any specific action, be sure to consult with your tax professional.
Here’s how you can roll over 401(k) assets to a Roth IRA:
* If you’ve contributed to a traditional 401(k) – You generally contribute pre-tax dollars to a traditional 401(k), so this money will be taxed when it’s rolled over to a Roth IRA. Given the benefits of a Roth IRA (i.e., tax-free withdrawals, no RMDs, more investment options than a 401(k) plan), this conversion might make sense, particularly if you think you’ll be in a higher tax bracket during retirement. However, you would need money available from another source to pay the taxes due on conversion.
* If you’ve contributed after-tax dollars to your traditional 401(k) – If you’ve contributed after-tax dollars to your traditional 401(k), you can roll over this money to a Roth IRA with no immediate tax consequences.
* If you’ve contributed to a Roth 401(k) – In recent years, many companies have offered a Roth option for their 401(k) plans. Essentially, the Roth option gives you the same ability to contribute after-tax dollars to your plan as you might have with a traditional 401(k). And, as with rollovers of after-tax dollars from traditional 401(k) plans, a rollover from a Roth 401(k) to a Roth IRA has no immediate tax implications.
NOT ALWAYS AN “EITHER/OR” DECISION
We’ve looked at different scenarios involving moving – or not moving – your 401(k) funds when you leave your employer. But your decision does not have to be an “either/or” one. You could, for example, make a partial 401(k) rollover, which might make sense for you under any of these circumstances:
* Your 401(k) has one particularly good investment option – Your 401(k) might have an investment option that has performed quite well and is not available to outside investors. In this case, you could keep just enough money in your 401(k) to hold on to that one investment, while rolling everything else out of the account to an IRA.
* You retire between age 55 and 59 ½ – During this time period, you have penalty-free access to your 401(k) funds, but you’d likely still incur the 10% penalty for IRA withdrawals. So, you might want to roll over part of your 401(k) to an IRA to take advantage of the increased investment options, while leaving enough money in the 401(k) to help pay for your living expenses until you reach 59 ½ and gain penalty-free access to your IRA funds.
* You have a large amount of employer stock in your 401(k) – If you own a considerable amount of employer stock in your 401(k), and this stock has increased greatly in value, you might not want to transfer it to a traditional IRA. When you eventually liquidate that stock, you would be taxed at your ordinary income tax rate, which could be as high as 39.6%, given current tax rates. If you moved the employer’s stock to a taxable brokerage account, and then sold the stock, you would only be taxed at your ordinary tax rate on the original “cost basis” of the stock – the amount it was worth when you added it to your 401(k) – but you would pay the more favorable capital gains rate, which currently tops out at 20%, on the gains earned by the stock. And you could still transfer the remainder of your 401(k) to an IRA.
REVIEW YOUR BENEFICIARY DESIGNATIONS
No matter what you decide to do with your 401(k) upon leaving your job, you might want to take this opportunity to review an often overlooked – but quite important – detail of your account: your beneficiary designation. This designation – which names the person or persons you want to receive your 401(k) funds upon your passing – is meaningful; in fact, it can even supersede the instructions you may have left in your will. It is a good idea to periodically review your beneficiary designations; this is especially true if your family situation has changed since you initially listed a beneficiary – for example, if you’ve divorced and then remarried.
WEIGH YOUR OPTIONS CAREFULLY
As we’ve seen, when you leave your job, and you need to decide what to do with your 401(k), you have several options. Which one should you choose? There is no single “right” answer for everyone. At The Retirement Network, we are here to help you evaluate your choices and make the right decision for your individual situation. You work hard for your retirement assets. We’ll help you make sure they continue working hard for you.