When you change jobs or leave a company, you’re faced with a crucial decision: what to do with your old 401(k)? This account may represent a significant portion of your retirement savings, so it’s essential to carefully weigh the pros and cons of each option. The article outlines four main choices:
1. Keep it with your old employer’s plan:
This option essentially means leaving your funds exactly where they are, managed under the umbrella of your former employer’s 401(k) plan.
- Detailed Pros:
- Continued Tax-Advantaged Growth: This is a significant benefit. Your investments continue to grow without being subject to annual taxation on interest, dividends, or capital gains. This allows the power of compounding to work its magic over time, potentially leading to substantial growth in your retirement nest egg.
- Potentially Lower-Cost Investment Options: Employer-sponsored 401(k) plans often have significant negotiating power due to the large amount of assets they manage. This can translate to access to institutional-class mutual funds or other investment vehicles with lower expense ratios (the annual fees charged to manage the fund) compared to what you might find as an individual investor. Over the long term, even small differences in expense ratios can have a noticeable impact on your returns.
- Familiarity and Ease: If you were satisfied with the investment options and the overall management of your old 401(k), keeping it there requires no immediate action or decision-making on your part. It’s the path of least resistance.
- Potential for Loan Provisions: Some 401(k) plans allow participants to take out loans against their balance (though this is generally not recommended as it can hinder retirement savings). If your old plan offers this and you anticipate needing this option in the future (again, proceed with caution), keeping the money there might be a consideration.
- Stronger Creditor Protection: Generally, funds held in ERISA-qualified retirement plans like 401(k)s have strong protection from creditors in the event of bankruptcy or lawsuits under federal law. This protection might be stronger than what’s offered to funds held in an IRA in some states.
- Detailed Cons:
- No Further Contributions: This is a major drawback. You can no longer contribute any new money to this account, limiting its future growth potential compared to actively contributing to a new plan or an IRA.
- Limited Investment Options: You are restricted to the investment choices offered within your old employer’s plan. These options might not align with your current investment strategy or risk tolerance. You lose the flexibility to choose investments that you believe have better growth potential or lower risk.
- Limited Withdrawal Options and Control: Accessing your money before retirement age (typically 59½) can be difficult and may be subject to the specific rules and regulations of your old employer’s plan. These rules might be more restrictive than those governing IRAs. You also have less direct control over when and how you can take withdrawals in retirement.
- Potential for Administrative Changes: Your former employer could change the plan administrator, investment options, or fee structure, and you might have limited say in these decisions.
- Multiple Accounts to Manage: If you have worked for several companies, leaving your 401(k)s with each former employer can lead to having multiple accounts to track and manage, potentially complicating your overall retirement planning.
2. Roll over the money into an IRA (Individual Retirement Account):
This involves transferring the funds from your old 401(k) into a new or existing IRA. This can be done through a direct rollover (where the funds go directly from the 401(k) to the IRA without you touching the money) or an indirect rollover (where you receive a check, but you must deposit it into an IRA within 60 days to avoid taxes and penalties). Direct rollovers are generally recommended to avoid potential tax withholding.
- Detailed Pros:
- Broader Range of Investment Choices: This is a significant advantage. IRAs offered by brokerage firms provide access to a vast universe of investment options, including individual stocks, bonds, exchange-traded funds (ETFs), mutual funds from various companies, and more. This allows you to tailor your portfolio precisely to your risk tolerance, time horizon, and investment goals.
- Greater Control and Flexibility: You have more control over your investment decisions and can adjust your portfolio as needed. You also have more flexibility in terms of withdrawal options in retirement, although early withdrawals before age 59½ are generally subject to a 10% penalty (with some exceptions).
- Potential Penalty-Free Withdrawals for Specific Expenses: While regular early withdrawals from IRAs are penalized, there are specific exceptions under IRS rules. These can include withdrawals for qualified higher education expenses, a first-time home purchase (up to $10,000 lifetime limit), certain medical expenses, and more. However, keep in mind that even if the penalty is waived, the withdrawal is still generally subject to income tax (unless it’s a Roth IRA rollover).
- Consolidation of Smaller Accounts: If you have multiple small retirement accounts from previous jobs, rolling them into a single IRA can simplify your financial life and make it easier to manage your overall retirement savings strategy.
- Roth Conversion Possibility: If you roll over a traditional 401(k) into a traditional IRA, you have the option to later convert some or all of those funds to a Roth IRA (although this will trigger a taxable event in the year of conversion). This can be a strategic move if you anticipate being in a higher tax bracket in retirement.
- Detailed Cons:
- Potentially Higher Investment Costs: While you have more choice, some investment options within an IRA, particularly actively managed mutual funds or certain brokerage services, might have higher expense ratios or fees compared to the institutional rates sometimes found in large 401(k) plans. You need to be diligent in researching and selecting cost-effective investments within your IRA.
- Less Protection Under Federal Law: As mentioned earlier, IRAs generally have less robust protection from creditors under federal bankruptcy law compared to 401(k) plans. However, many states offer some level of protection for IRA assets. It’s worth understanding the specific laws in your state.
- Responsibility for Investment Decisions: With an IRA, you are solely responsible for making investment decisions. If you are not comfortable managing your own investments, you might need to seek professional financial advice, which could incur additional costs.
- Complexity of Choices: The sheer number of investment options available in an IRA can be overwhelming for some individuals.
3. Roll over into a new employer’s plan:
This involves transferring the funds from your old 401(k) directly into your current employer’s 401(k) plan.
- Detailed Pros:
- Consolidation of Retirement Savings: This is a key advantage, bringing all your workplace retirement savings under one roof. This can simplify tracking your progress and managing your overall asset allocation.
- Potentially Lower-Cost Investment Options: Your new employer’s plan might also offer access to institutional-class funds with lower expense ratios.
- Potential for Loan Provisions: If your new employer’s plan allows for 401(k) loans, you might have access to this option in the future (again, use with caution).
- Continued ERISA Protection: Funds rolled into a new employer’s 401(k) continue to be protected under federal ERISA law.
- Simpler Administration: Dealing with one retirement account through your current employer can be administratively easier than managing multiple accounts with former employers or separate IRAs.
- Detailed Cons:
- Not All Employers Accept Rollovers: You must first verify that your new employer’s 401(k) plan allows incoming rollovers from other qualified retirement plans. Some plans may not offer this option.
- Need to Understand the New Plan’s Rules: You need to carefully review the investment options, fees, withdrawal rules, and other features of your new employer’s plan to ensure they align with your needs and preferences. The investment choices might be more limited than what you could access in an IRA.
- Potential for Less Investment Flexibility: Similar to your old 401(k), you are limited to the investment options offered within your new employer’s plan.
4. Cash out:
This involves taking a direct distribution of the funds from your old 401(k) in cash. This is generally the least recommended option due to the significant tax implications and penalties.
- Detailed Cons (and why you should likely avoid this):
- Immediate Income Taxes: The full amount you withdraw will be taxed as ordinary income in the year you receive it. This can significantly increase your tax liability for that year.
- 10% Early Withdrawal Penalty (if under age 59½): If you are under the age of 59½, the IRS will typically impose a 10% early withdrawal penalty on the taxable portion of your distribution, in addition to the regular income taxes. This can erode a substantial portion of your retirement savings.
- Reduced Retirement Savings: Cashing out significantly reduces the amount of money you have working for your future retirement. You lose the potential for future tax-advantaged growth on those funds.
- Missed Opportunity for Compounding: By taking the money out, you halt the power of compounding, which is crucial for long-term wealth building in retirement accounts.
- Potential for Lower Future Social Security Benefits: While not directly linked, reducing your retirement savings now could put more pressure on Social Security benefits in the future.
Key Considerations for Your Decision:
- Your Age: If you are close to retirement, your decision might weigh more heavily on immediate access and potential withdrawal strategies. Younger individuals might prioritize growth potential and flexibility.
- Your Tax Bracket (Current and Expected): If you anticipate being in a higher tax bracket in retirement, rolling into a Roth IRA (if eligible, or by converting) might be beneficial. If you expect a lower tax bracket, a traditional IRA rollover might be more suitable.
- Your Investment Knowledge and Preferences: If you are comfortable managing your own investments and desire a wide range of options, an IRA rollover might be appealing. If you prefer a more hands-off approach, staying in a 401(k) might be simpler.
- Fees and Expenses: Carefully compare the fees associated with each option, including investment expense ratios and administrative costs.
- Creditor Protection: Understand the level of creditor protection offered by each option in your state.
- Your Overall Financial Plan: Consider how your decision about your old 401(k) fits into your broader retirement savings strategy and financial goals.
In Conclusion:
Deciding what to do with an old 401(k) is a significant financial decision. While keeping it with your old employer or rolling it over to an IRA or a new 401(k) are generally prudent options that allow your savings to continue growing tax-advantaged, cashing out should typically be avoided due to the significant tax and penalty implications. Carefully evaluate your individual circumstances and consider seeking advice from a qualified financial advisor to make the best choice for your long-term financial well-being.