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Should I Rollover My Old 401k?

If you have ever left a job with a company that provides a 401k plan for retirement savings, you have probably been faced with a decision: What do I do with my 401k plan? After helping clients with this decision thousands of times throughout my career, I can attest that the answer could be different for everyone depending on their individual situation.  

While you are working for a company, you are listed as an “active” employee. When you leave, after about 30 days, your status is generally updated to either “terminated” or “retired”. There are other statuses, but we will focus on the most common. Terminated sounds terrible, but it just means that you are no longer an employee. There are 4 major options that we will discuss for your 401k when you are no longer active: 

  1. Do nothing and leave your funds in the 401k plan 
  1. Cash out the 401k 
  1. Roll the 401k to a new employer’s 401k 
  1. Rollover to an IRA 

Do nothing. When you leave a company, the vast majority of 401k’s will allow you to leave your money in the plan. This requires no action. You can still make changes to the investments, and possibly withdraw money, but obviously you won’t be adding more to it. Since contributions were made through payroll deductions, that all stops. The pros to leaving in the plan is the fact that you do not have to do anything. You may be happy with your investment choices. Some plans offer lower cost mutual fund shares vs. their retail counterparts. You may have very flexible withdrawal options as well. The downside to leaving your money in the plan is that most plans offer limited investment choices. You may have limited withdrawal options. In some plans it is all or nothing, and no partial withdrawals, which could be a problem when you need a small amount of cash from the plan. Some plans are very flexible and may even offer monthly automatic payments. You will need to check with your 401k provider on the options for withdrawal. If the plan allows for partial withdrawals, there is usually mandatory federal tax withholding at 20%, which could be excessive if you are in a lower tax bracket. Some plans charge an annual fee that is passed on to the participants. The exception to staying in the plan would be if you have a very low balance, usually less that $5000. You could be notified that you need to do something within a certain time period of they will just cut you a check. 

Cash out the 401k. This option unfortunately is a popular option for many people. I remember reading a study from a major 401k provider several years ago. Out of all of the terminated participants who left a company in that year, around 35% cashed out their 401k. This really got my attention. Sometimes the 401k balance may not seem like a lot of money if you contributed for a short period of time, but with the magic of compounding interest, it could grow to be very significant later in life. 100% of the 401k distribution will be taxed as ordinary income, except for roth contributions or after-tax contributions. Federal tax will be withheld at 20%, and if you are under 59.5, the distribution will be subject to a 10% early withdrawal penalty when you file your taxes (there are a few exceptions). There is also an exception called the Age 55 Rule, which we will cover later. If you have any loans outstanding, those will “default”, which sounds bad, but there are no credit implications. It just means the outstanding balances will be reported as ordinary income. 

Roll the 401k to a new employer’s 401k plan. This option would be for someone who wants to consolidate. If the thought of keeping up with too many accounts is too much, and you are going to work for someone else who offers a 401k, this may be a consideration. Rolling in your old 401k may count towards your ability to borrow from the new plan. If the new plan has more investment choices, you could invest these funds into them. The downside to this option is that you are still limited to the plan rules and investment choices. If you need access to the funds, you may not be able to get at them until you leave the new company. Many plans offer withdrawals for this source of money (Roll-Ins) while you are active. If you need quick access, this may not be a good option because of the plan’s process for getting money out, like mailing a check or paperwork. 

Rollover to an IRA. This is one of the most popular options, and for good reason. You can open a Rollover IRA with a number of institutions, such as banks, brokerage firms, insurance companies and others. The IRA is different because you are no longer a participant in a 401k where the rules are out of your control, but rather now you are a client. Using a brokerage firm as an example, your IRA is a brokerage IRA and you can literally invest in almost anything that you want. You can buy stocks, bonds, ETF’s, mutual funds, CD’s, precious metals and trade options. For most people, it is not that you would, but you could. You can usually get help from a brokerage company in terms of education on investing, and there are countless books, videos and podcasts to explain these concepts. If this is too much, or you just want to make sure that it is done right, you can have your funds professionally managed. If you need to withdraw money, you can link your IRA to your bank with most firms, or you can request a bank wire for same day funds. Withdrawals from an IRA are NOT subject to mandatory withholding, unlike a 401k. You can withhold nothing, or some other percentage that you like. A Rollover IRA offers the most all-around flexibility.  

Some people appreciate the simplicity of the 401k and lack of choices. Many people make mistakes with more investment choices, like trading stocks that lose value. There are many cases of unknowing people buying IRA annuities, which are insurance products, and years later discover that they are stuck with them with no liquidity. You need to be careful and consult with a competent professional that will help you make a good decision. 

Circling back to the 55 Rulethis is very important is you leave a company in the same calendar year when you are at least age 55, but not yet 59.5. If you were to rollover to an IRA, the normal rules apply to the IRA, and you need to be 59.5 to withdraw money with no penalty. Federal taxes always apply. If you were at least 55 when you left your old company, any withdrawals from the old 401k plan would be taxable, but penalty free. Now, as we discussed, the plan may have limited options for withdrawal as a terminated participant. However, if you need money before 59.5, the plan may allow for a monthly fixed payment from the plan or partial withdrawals. This could affect your decision to rollover to a new 401k, or an IRA. If the plan offers no partial withdrawals or automatic payments, and you need money, there is usually another option. You could do a full rollover of the 401k to an IRA and do it on a percentage basis. For example, you could instruct the old plan to roll over a certain percentage to your Rollover IRA and send you a check for the remaining percentage. That distribution would be taxable, but penalty free. This is a one-time option and should be carefully considered. 

This article does not cover every option, consideration or special tax treatment. Please consult with a professional who deals regularly with 401k plans to help you make a good decision. 

John Weller is a CERTIFIED FINANCIAL PLANNER™ professional based in Southlake, Texas

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Investment advisory services offered through Avantax Advisory ServicesSM.

1560 E. Southlake Blvd. Suite 100
Southlake, TX 76092

Investment advisory services offered through Avantax Advisory ServicesSM.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services offered through Avantax Advisory ServicesSM.

1560 E. Southlake Blvd. Suite 100
Southlake, TX 76092

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