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trust. It was the end of 2008. After a long time contemplating it, I finally pulled the trigger. I gave my supervisor my resignation letter. It was past time to go elsewhere. It was probably the second-best professional move I ever made. The best one was what I did a couple of years later when my new employer decided to lay me off. Then, realizing job security was a myth in today’s world, rather than look for another job, I started
my own small business. That led to the success I’ve experienced for the past 12½ years. As great as that journey was, I want to concentrate here on one aspect in common to both job changes. In both cases, I had to decide what to do with my
retirement plan balances. In the first case, it was a 403(b) plan, like a 401(k) for non-profits and certain government entities. In the second, it was an actual 401(k). In both cases, I made the same
choice. Before I spill the beans, let me first emphasize how important it is to prioritize your 401(k) whenever you transition jobs. “It’s important to keep your eyes on this most important retirement planning asset,” said Yvonne Marsh, CFP, CPA, and Principal Advisor at Marsh Wealth Management. “It’s easy to lose track of it if you leave it behind at your previous employer. For example, I just had a client send
me a notice she received about a $116,000 401k she had left behind from a previous employer over 20 years ago – she had totally forgotten about it!” If you’re quitting, like I did that first time, or suffering a layoff like my second time, you have either 3 or 4 options, depending on your account balance. So, which should you choose? There is no answer that’s right for everyone. As I like to say, personal finance is just that – personal. What’s right for me now may not be right for you and may even be
wrong for me at a different time. Below we’ll look at the pros and cons of each option. But first, note that if your balance is under $1000, your old employer may simply make the choice for you, withholding 20% toward your possible tax liability and sending you a check for the rest. See below for more details of what that could mean. If your balance is over $1000 but less than their threshold for allowing the money to stay in the plan (usually $5000), your old employer must give you at least 30 days’ notice about your right to withdraw the balance. If you fail to respond, they will most likely establish a rollover IRA for you. Pros and Cons of Leaving the Money Where It IsThe Pros of Leaving the Money in the Old Plan?
The Cons of Leaving It There?
As you can see, there are plenty of potential arguments for both sides. For some people, this may make the most sense, while for others, it would be less than optimal. “When a person leaves their job, there are lots of reasons why they may want to leave their 401K where it is,” said Joe Dunat, Wealth Advisor at Sturkie Wealth Management. “It has strong protection from
creditors in cases of bankruptcy and lawsuits, and potentially one can even still take out a loan from the 401K, which is not available in IRAs.” Pros and Cons of Rolling the Money into Your New Employer’s PlanThe Pros of Rolling the Money Over to the New Plan?
The Cons of Rolling Over Into the New Plan?
A Word on How You Do the Rollover
The latter is generally a bad idea. The law requires your old employer to withhold 20% of your balance in case you owe taxes, and you won’t get that back (if at all) until you file your tax return the following year and get a refund. Despite this, you’ll only have 60 days to deposit the full amount into the new plan, including that missing 20%. If you can’t come up with the extra cash, you’ll suffer three consequences:
If you have an urgent and temporary need for some money, explore other options such as a 401(k) loan from the new plan or any other plausible short-term solution. Use the indirect rollover only if there are literally no better options. You should also consider if there are any other hidden rolling costs. “Some plans are wrapped in annuities products, and those can be expensive to be able to roll out of,” said Erik Nero, CFP and Founder of First Stepwealth. “If someone’s a little earlier in their savings career, it probably makes sense to remove those kinds of associated costs. These are typically seen with smaller company types of plans, as a lot of the insurance carriers are really in that end of the market, whereas it’s less prevalent among larger employers,” he said. “So workers just need to take a look at the summary description document of their plan to see if there are any costs associated with rolling and weigh those in,” he added. A Word on Another Possible DecisionAnother decision you may need to make when doing a rollover is whether to choose a Roth option if your new employer’s plan has that available. If your original plan was a Roth and the new plan has no Roth option, you’re almost definitely better off doing the rollover into an existing Roth IRA (see below). This is because it preserves the tax-free nature of your money, and if the IRA has been open for more than 5 years, you may be able to access all your contributions tax and penalty-free. Note, however, that making even such a “free” withdrawal robs your future self of irreplaceable resources in retirement. If your old plan wasn’t a Roth and the new one offers a Roth option, you may be able to convert your existing balance into a Roth. However, come tax time, you’ll need to pay taxes on the converted amount as if it was current income. Pros and Cons of Rolling the Money into a New or Established IRAWhat May Be the Pros of Rolling the Money Over to an IRA?
What May Be the Cons of Rolling the Money Over to an IRA?
Again, if you choose this option, a direct rollover is almost always your best option. If your old plan was a Roth, you can (and likely should) do the rollover into a Roth IRA to preserve its tax-free status. If you do this, it’s best to roll it over into an existing Roth IRA if you have one since the 5-year clock until you can withdraw your contributions tax and penalty-free has already been ticking for a while, potentially past the 5-year mark. If your old plan wasn’t a Roth, you may still want to consider converting it by rolling over into a Roth IRA, especially if you expect your income to be lower than usual this year, especially if this places you in a lower tax bracket. Pros and Cons of Simply Withdrawing the MoneyLet’s Start with the Cons Because They’re Overwhelming
In most cases, this is foolish in the extreme. Say you’re leaving your old job when you’re 25, and you have $2500 in your old plan. You’re starting a new job, and your total marginal tax rate is 30%. When you cash out the $2500, the plan will withhold 30%, 20% toward taxes, and 10% early-withdrawal penalty. At tax time, you’ll actually owe another ~10% because your marginal tax rate isn’t 20%, it’s 30%. This means that out of the $2500, you end up with just $1500. Further, if we assume a long-term average annual real (after inflation) return of 6% and that you’ll retire in 42 years at age 67, your $2500 would have grown to almost $29,000. As you can see, you’d be grabbing $1500 now, but you’ll lose $29,000 (inflation-adjusted) when you’ll need the money to be able to retire. Not a super-smart choice in most cases. “The 401(k) is designed to be a long-term retirement savings vehicle, and that’s why Uncle Sam incentivizes you to use it with the gift of a tax deduction for your contributions,” said Marsh. “Take it out early, and you’ll lose a chunk of it to taxes and penalties. There are a few exceptions to the 10% penalty rules, but not many.” Cases Where You Might Need to Do This Anyway and How to Minimize the DamageIf you absolutely must take the money to cover an emergency (think serious medical problems; extended loss of income; having your home destroyed, e.g., by fire or tornado; etc.), you can do so. In some cases, you may not owe the 10% penalty, and if the plan was a Roth 401(k), you won’t even owe taxes. If this is your situation, here are your three steps:
A Note on VestingWhen I left employment, both times, I was fortunate enough that my employers’ plans were set up such that all employer contributions were vested immediately. This is not true in all, or even in most cases. Most employers follow either a gradual vesting schedule, where employer contributions become yours in steps over time or a deferred “cliff” vesting, where it becomes yours all at once after a certain length of employment. Talk with your old employer’s Human Resources Department to find out the details in your case so you aren’t blindsided when you get significantly less out of your old 401(k) plan than what your most recent statement showed. What Happens if You Took Out a 401(k) Loan from Your Old Plan?It used to be that if you had an outstanding balance on a 401(k) loan and left employment, you had very little time to pay it all back, or the remaining balance would become a de-facto early withdrawal, with all the negative consequences mentioned above. Following the 2017 “Tax Cuts and Jobs Act,” if you took out a 401(k) loan from your old plan and are leaving employment for any reason before paying it all back, you can continue making payments to a rollover IRA. This new tax law gives you until your tax filing deadline (including all extensions) to finish paying back the loan in full before considering the unpaid balance an early withdrawal, subject to all the consequences of such a withdrawal. The Bottom LineHaving a balance in an old employer’s 401(k) plan is, obviously, better than not having it. If it does exist, you need to choose whether to keep it there (subject to a minimum balance requirement), roll it over into your new employer’s 401(k) plan or an IRA, or potentially cash out that balance. In the above, you can see the pros and cons of each option, as well as some other relevant details. Given how significant the consequences may be, you should contact your accountant and/or financial planner to make the most well-informed decision you can. And now, I’ll finally share what I did in both cases. I did a direct rollover into traditional IRAs. Since then, the money in these rollover accounts has grown 4-fold. Not too bad, huh? Now it’s up to you to save and invest according to what’s right for you. Need a Helping Hand? Find Your Next Financial Advisor on Wealthtender📍 Click on a pin in the map view below for a preview of financial advisors who can help you decide what to do with your 401(k) when you quit your job. Or choose the grid view to search our directory of financial advisors with additional filtering options. 📍Double-click or pinch pins to view more. Are you ready to enjoy life more with less money stress?Sign up to receive weekly insights from Wealthtender with useful money tips and fresh ideas to help you achieve your financial goals. Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions. About the AuthorOpher Ganel My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals. Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/. Disclaimer: To make Wealthtender free for our readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a natural conflict of interest when we favor their promotion over others. Wealthtender is not a client of these financial services providers. Learn how we operate with integrity to earn your trust. |