On average people change jobs 12 times throughout their lives. This often means a shoe box full of old 401k retirement statements. Many people forget about these old plans, costing them potentially thousands of dollars if funds are not properly diversified. You may have been advised to “roll over” your old 401k or old 403b. But is that truly best for you?
Whether you are transitioning to a new employer or retiring from the workforce, you'll want to avoid some very common mistakes. Fortunately, by working with a Certified Financial Planner, you can make well-informed decisions, analyze trade-offs and avoid surprises. Below I examine the four options everyone has available to them with their old employer retirement plan.
1) Leave the money in your former employer's plan;
2) Roll the funds into a new employer's plan (assuming you continue to work);
3) Transfer the assets into an IRA account; or
4) Cash out the balance, paying the applicable taxes and penalties (which depend on your age and circumstances).
1) Leave the money in your former employer’s plan – This is the least common of all four options. You are unable to contribute into the old 401k once you leave the employer. Any employer matching contributions received while working at your old employer are discontinued. Lastly, many 401k plans are limited to 15-20 mutual funds, making it difficult to customize a diversified portfolio based on your ideal retirement age, risk tolerance and market environment.
On the flip side, there are a few reasons to keep money at your old 401k. If you are 55yo and planning to retire, your 401k provider will allow you to take withdrawals without the standard early 10% penalty. If you are over 70 ½ years old and still working, you may avoid taking your required minimum distribution until you retire as long as you are not a greater than 5% owner of the company. Lastly, if you own company stock within your 401k plan there is a potential tax advantage called NUA (Net Unrealized Appreciation). This strategy allows an employee the potential to receive long term capital gains treatment on the appreciation of their company stock if selected within the 401k. Long term capital gains rates can be as low as 15% compared to paying higher ordinary income tax on any appreciation of funds.
2) Roll the funds into a new employer's plan (assuming you continue to work) – Many people I find do this when they are not sure what to do. This is better than the above because at least you are consolidating your retirement funds into one plan, allowing compounding growth to work in your favor. This is a viable option when your new employer 401k plan offers you over 40-50 low cost investment funds spread throughout different assets classes. Still, this option is limited on investment selection compared to IRAs.
3) Transfer the assets into an IRA account – The Individual Retirement Account option may be the best due its investment flexibility. Compare the 15-20 mutual funds offered in the old 401k plan vs. the 1000s of funds available in the open marketplace. With IRAs you have access to lower cost Exchange Traded Funds (ETFs), which cost typically 1/3 that of their mutual fund counterparts. Consulting with a competent Certified Financial Planner allows you to get professional advice to narrow down which funds are best for your situation. Make sure to use a large credible custodian like a Charles Schwab, Fidelity or Vanguard.
Generally, accessing funds from an IRA will cause an early withdrawal penalty of 10% of additional tax. However there a few exceptions for IRAs to avoid this early distribution penalty such as using funds for a first time home purchase (up to $10,000), qualified education expenses, health insurance premiums while unemployed and unreimbursed medical expenses.
Retiring early? IRAs have a rule called the IRS 72t which allows someone to take periodic withdrawals from their IRA before 59 ½ years old without early penalties. This works as long as one takes a series of substantial equal payments for the later of 5 years or reaching 59 ½ years old.
Lastly, there is the “stretch IRA” concept. This is an estate planning strategy that allows you pass on your IRA funds to multiple generations. This give beneficiaries more time to enjoy compounded tax deferred growth. Great for families with young kids due to the lower IRS required minimum distribution, allowing more funds in the IRA to stretch over time.
4) Cash out the balance, paying the applicable taxes and penalties – Not the wisest choice if you are still working. Any amount taken before 59 ½ years old is generally subject to the early 10% distribution penalty in addition to ordinary income taxes being due on what you withdraw.
In summary, take control of your own retirement by educating yourself and seeking professional advice on all your options. Make sure you seek a competent Certified Financial Planner that is properly licensed to advise you on all your options. There are many types of financial advisors out there to steer clear from but I’ll save that for another blog post =). Questions, comments or if you’d like to set up a no-cost review contact me today and I’ll be happy to talk.
Dustin Javier, CFP® AWMA®
CERTIFIED FINANCIAL PLANNER™
President | Dean Johnson Advisory, LLC