When you transition to a new job or are retiring, it’s an exciting time full of fresh possibilities. But because it can also be such a hectic time, there’s one thing that many people set to the side and then quickly forget about as they dive into their new role… their old 401k. Unfortunately, by forgetting, they are unknowingly leaving a great opportunity to maximize retirement savings and returns on the table.
You actually have several options for your 401k with your former employer. These include:
Cashing out
Leaving your money in your old employer's plan
Transferring your money to your new employer’s 401k plan
Rolling your money over into an IRA
(Tip: if you are over age 59 1/2, you may also have options for your 401k with your current employer, too, so make sure you read through to the end!)
SHOULD I CASH OUT MY OLD 401K?
I generally do not advise my clients to cash out their 401k. Cashing out means that whatever you withdraw will be taxed as income, and if you’re under 59½, you would also be hit with a 10% early withdrawal penalty. Together the tax and the penalty can quickly become a very significant percentage or your account value that you are giving up. Beyond that, you lose out on the long-term tax-deferred growth that your 401k account offered, which can significantly impact your retirement savings over time. So, unless it is truly necessary, I advise you to take this option off the table altogether.
SHOULD I LEAVE MY OLD 401K WITH MY FORMER EMPLOYER?
Typically, if your plan sponsor allows it, you can leave the funds in your old employer’s 401k. This option is straightforward because you really aren’t doing anything; you’re simply leaving the money where it is. It’s a much better choice than cashing out, but there are some potentially significant drawbacks. While easy, this option often lacks flexibility in terms of investment choices since you will be limited to the investment options offered by the employer-sponsored plan. Those will not always fit well with your broader financial goals and may not match your risk tolerance or time horizon as you age nearer to retirement.
Also, having your investments spread out among several different institutions makes it difficult to create an optimized and cohesive portfolio because each employer typically only offers a limited selection of investments that may not partner up well with other employer offerings. In other words, each account that you have should be a perfectly matched complement to your other accounts. When you are piecing together a portfolio from limited options from multiple places, that becomes harder to do. So, generally speaking, I would say that this is better than cashing out, but not the most favorable option if you want to make the most of your retirement savings.
SHOULD I ROLL MY OLD 401K OVER INTO MY NEW 401K?
That brings us to your next option, transferring the funds to your new employer’s 401k. This can be a good choice since it consolidates your retirement savings, which can be helpful for simplicity. However, as I mentioned before, this option typically also offers few investment choices and less personalized control, which may or may not align with your evolving financial goals.
Most employer plans are limited to a small set of mutual funds or other investment options, which might not provide the diversification, risk tolerance, and flexibility needed to meet your specific objectives. I would liken it to you trying to build a custom home, but allowing someone else to limit you to choosing from the available floorpans of one single builder. You could get a livable house, but it probably wouldn’t be the perfect house for you that a truly custom home with your floorpan of choice would be. The same principle can be applied to your investments. You really need more options to get the best match for you.
Another consideration is that employer sponsored plans may give you less control over how and when to adjust your portfolio. 401k accounts typically allow or automatically rebalance on a limited basis, possibly only one time per month or just a few times per year, which means you can get stuck with your investments carrying higher risk than you want until the next available time frame that allows for a rebalance. (Because the holdings in your 401k are going to grow at different rates, rebalancing must be done as needed to maintain your investment strategy, appropriate risk tolerance, and correct asset allocation for your projected retirement date.) To sum this option up, transferring the funds of your old 401k to your new employer’s plan is a better option than the previous two options, but I still think you can do better.
SHOULD I ROLL MY OLD 401K OVER INTO AN IRA?
If you want additional control and a more personalized investment, I recommend the fourth option — rolling the funds over into an IRA. Because IRAs generally offer access to a wide variety of investments, including stocks, bonds, and exchange-traded funds (ETFs), they can help you build a more customized and comprehensive portfolio for your unique needs and goals, just like the custom home analogy I mentioned before.
You can also choose between traditional or Roth IRAs, depending on your tax preferences, which adds flexibility and further enhances your retirement strategy. (If you need help deciding which type of IRA is best for you, check out my previous blog post here.) In regard to rebalancing, an IRA is typically going to allow you to rebalance more often than the average 401k plan will, which is another advantage. Finally, an IRA allows you to collaborate with an investment advisor to develop a personalized investment strategy to create and maintain the IRA that will be the ideal complement to your portfolio.
You may be wondering, what if I left an employer long ago? Did I miss my opportunity? The good news is that you did not. If you have money sitting in an old employer’s plan, you can move it into another qualified plan — like an IRA — at any time without taxes or penalties. In fact, if you are above age 59 1/2, then you may even be able to move money from your current employer’s 401k plan into an IRA. The only caution I want to raise in both scenarios is that if you move money from your 401k, you have a limited amount of time to roll it into another qualified plan before you may owe taxes and penalties. So if you choose this option, please be intentional to do it within the allowed time frame; after all, you want to keep as much of your money as possible.
If you’re unsure about the best course of action or how to implement your choice, consulting with a financial advisor is a smart move. An advisor can help you navigate the rollover process, explore your options, and develop a strategy that fits your financial goals and vision for retirement. And if you are consulting with a fiduciary such as myself, you can rest assured that we are required to act in your best interest.
Email me if you still have questions or need clarification; I love to hear from you!
Sincerely,
P.S. If you missed my earlier post, How to Prioritize Your Retirement Contributions, you can go back and read that here. It really does go hand in hand with this one.