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 will be increasingly scrutinized if the Department of Labor’s (DOL) fiduciary rule is enacted. The rule mandates that advisors providing retirement advice act in the best interest of the client, which is called a fiduciary responsibility. The purpose is to protect retirement funds from professionals looking to profit at the expense of investors’ interests and ensure that the advice investors receive is right for them. Wealthspire Advisors, which has been a fiduciary since its inception, continues to believe that the best way to answer this question is to discuss the pros and cons of the four available options and let the client decide what to do with an old 401(k).
The four options are:
1) Leave the money in your existing 401(k),
2) Roll your 401(k) into your current employer’s plan,
3) Roll your 401(k) into an IRA, or
4) Take the cash
Before detailing each of these, it’s important to clarify that 401(k)s and traditional IRAs share many of 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 Both are tax-deferred, which means that dollars within these accounts are not subject to income tax until they are withdrawn.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 accounts, meaning that funds within these accounts are never subject to income tax because they have been funded with after-tax dollars. 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. Retirement plans want to grow in size because the larger the 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, infrequent rebalancing, and potentially increased administrative fees. If you have multiple jobs over the course of your career, you can wind up accumulating just as many employer retirement accounts, making it difficult to strategically allocate your investment portfolio and easy to alienate previous accounts.
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, as this would allow you to consolidate your retirement plans into a single account. Eliminating accounts makes your portfolio easier to manage and also allows investors who are approaching age 70.5 to avoid required minimum distributions (RMD), which they would have to take from an IRA. 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, since they are not required to. 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. The bare minimum to satisfy this standard is a stock fund, a bond fund, and a money market fund, but typically plans offer more than that. Many 401(k)s offer low-cost passive index funds which are the appropriate investment vehicle for the typical retirement saver. However, plenty of retirement plans have a lineup consisting of expensive actively-managed funds that cost more than 1% annually, or index funds that cost five to fifteen times greater than the same index fund purchased outside of the plan. This is a red flag that investors should look out for before rolling over previous 401(k)s into the plan. 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 for a few reasons:
- IRA rollovers 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, and
- They provide access to a much 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, the Rollover IRA gives 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 age 70.5, and
- A backdoor Roth IRA contribution would likely create a tax liability.
Depending on what state you reside in, one additional benefit of a 401(k) that a Rollover IRA lacks is great creditor protection. This could be a relevant consideration if you are a high income earner in a field with individual legal risk.
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 59.5 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.
Ultimately, there are many 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 in order to determine which characteristics are important to you before moving forward.