What can I do with my employer-sponsored plan when I retire or change jobs? Here are some options for your employer-sponsored plans
Whether a client has recently changed jobs or just retired the same question is brought up – ‘what should I do with my 401k plan?’. While many will say it is best to roll the balance over to an IRA, or leave it in the current 401k, I find that the ultimate decision varies from situation to situation, and of course, what you are attempting to accomplish on the back end.
Below, I walk through 4 options folks can consider:
1. You can keep the funds in the current 401k plan
The easiest option can be to leave the current balance in the plan. You can consider this path if you are happy with the investment options available in the plan (compared to the new plan options if you change jobs) and if the cost to keep it there is still reasonable. Moreover, if you are retired you want to make sure there are enough options available in the plan to create an efficient distribution strategy – i.e. having a systematic approach to set aside 1-3 years of income in something safe and then subsequently withdraw these amounts on a monthly or annual basis. This also requires you to full up this ‘distribution bucket’ every so often. This more so concerns someone who is invested in a Target-Date Retirement Fund, as employing this strategy can be a bit challenging.
While Target-Date Funds are great for accumulating assets, I find that they come up short during the distribution phase - as you can only take money from the one fund. As a reminder, Target-Date funds are a collection of different stock and bond funds under one umbrella (the actual target date fund), so, when you sell the Target-Date Fund to take a withdrawal, all the underlying holdings are being sold pro-rata. Therefore, you cannot choose where exactly the distribution is coming from – i.e. the underlying bond fund could be having a poor year, while the stock fund is up, so your instinct may be to sell the stock fund to collect the profit, but you do not have this choice with the Target Date Fund. You will still sell a portion of the bond fund as a decreased value, and vice versa.
Furthermore, when folks retire, I typically suggest that they break out the Target-Date Fund allocation and simply own the underlying individual stock and bond fund options. By doing so they can maintain the same overall allocation, but have more flexibility and choice regarding the asset classes they aim to take their withdrawals from. Moreover, they can also use the short-term bond / money market fund to park their 1-3 years of future income ahead of time – this can help to more efficiently manage emotions during times of market volatility, as you would know you had a few years of the income you will need already set aside.
2. You can consider rolling the old 401k balance into the new 401k plan
Moving the 401k balance into your new 401k plan can also be a simple option. Doing so will allow you to keep your accounts organized as these two accounts will now be combined under one roof. However, prior to moving the funds into the new plan you will want to confirm that the new 401k plan will accept this rollover, that the investment options offered are equal to, if not better than the options offered in the prior 401k plan, and the actual costs of the 401k plan are the same, if not lower. Pretty straight forward here.
3. You could consider rolling the balance into an IRA (Individual Retirement Account)
A very common choice is to roll the 401k balance into an IRA. If your 401k balance is all pre-tax, you would roll the balance into a Traditional IRA (Rollover IRA), if the balance is ROTH, you would roll it over into a ROTH IRA (Rollover ROTH IRA) – of course if there is a mix (pre-tax & ROTH) it would be split between the two IRA’s.
An IRA is very similar to a 401k plan with regards to the tax treatment (before or after tax), but an IRA is set up and owned by an individual investor, where a 401k plan is set up by an employer.
Typically, folks will look at this option to control costs and to have more investment freedom. With 401k plans there are usually administrative fees associated with the plan, in addition to the expense ratios built into the investment options. With an IRA, depending on the custodian you use to open the account, there is almost never a cost to open the account, or an annual account fee. However, do not be fooled, you are paying a cost behind the scenes in some way, shape, or form – whether this is through the fees the custodian collects on the sweep account, trade execution, expense ratio of this custodian’s proprietary funds if you choose to use them, etc. Or some do have transparent annual account fees, however as I said it does depend on the custodian.
In any event, when you invest within an IRA your investment options are endless, as you can purchase mutual funds, exchange-traded funds (ETFs), individual stocks, individual bonds, and the list goes on and on. This is vastly different than your 401k plan, where you can only pick from the options the employer plan provides you with. In most cases, having more flexibility and choice is a great thing as it allows you to further diversify your allocation and utilize a wide variety of asset classes to assist you in potentially controlling portfolio volatility, long term growth, and your distribution plan – which you can design to be even more systematic within an IRA.
The process of rolling the 401k balance over to an IRA is fairly simple – it usually requires you to work with the custodian that holds your 401k plan to complete any required paperwork (if applicable), then instruct them to make the rollover check payable to the custodian that holds your new IRA. As a note, from the time of the rollover distribution you have 60 days to deposit the check into the new IRA. From there, you are off to the races!
Once you have the 401k balance deposited into your IRA, you can also begin to more seriously consider, and take action with ROTH conversions with any pre-tax funds (see my previous blog post for more info).
4. Some folks do consider cashing out the 401k plan balance (not recommened!!)
To be crystal clear, this is by no means a recommendation to cash out your 401k plan, as this is typically not a smart move. Especially if the account balance is 100% pre-tax, you will owe taxes on the distribution amount, and a 10% penalty if you are under age 59.5.
In any event, I am including this option as people do still go down this path despite the negative consequences, but more importantly to educate folks on the variables that should be considered when making this decision.
To illustrate this – as an example let’s say you are under age 59.5, recently changed jobs at age 35, you have $200,000 in your pre-tax 401k plan, and you are planning a home renovation. The renovation will cost $100,000 and you do not have enough liquid cash to pay in full, and you are opposed to using a financing strategy. You decide to take $100,000 distribution from this 401k plan - since you are under 59.5 you will automatically owe a 10% penalty - $10,000 – then you will pay income tax on the full $100,000 (let’s use 20%) - $20,000 – for a grand total of $30,000 in taxes and penalties. So, instead of ending up with $100,000, you end up with $70,000. Even if you decided to take more out to net $100,000 you will still be faced with a higher level of taxes and fees (approximately $142,000 to net $100,000!!).
As you can see from the example, this is typically not the most efficient option from a tax and fee perspective, but also from an opportunity cost perspective as this money will no longer be invested and have the potential to grow over the next 10, 20, 30+ years. Furthermore, sometimes folks do not have any other choice and they need to take out funds from their 401k plans early as a result of unavoidable life events or economic hardship, so in this case, it is important the people understand the costs involved.
What I find is the most interesting about this option is how many people actually do this when they change jobs. In a study completed by the Harvard Business Review from 2014-2016, they discovered that out of 162,360 exiting employees across 28 retirement plans in the U.S., 41.4% of these employees cashed out their 401k account balance. Along these same lines, 85% of the folks who choose to withdraw, did so with 100% of the account balance. You may state that this percentage could be made up of younger folks who had small balances, but even so, this is a shockingly high percentage.
Again, this not something I ever recommend that a client does - especially if they have not gone through the numbers to understand not only the impact of taxes and fees, but also on their longer-term planning.
I hope this was a good review for folks on the options they have with their employer sponsored plans. All questions on the above are welcomed and encouraged.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.
https://hbr.org/2023/03/too-many-employees-cash-out-their-401ks-when-leaving-a-job - used for data on cash out 401k option
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Before deciding whether to retain assets in a 401(k) or roll over to an IRA, an investor should consider various factors including, but not limited to, investment options, fees and expenses, services, withdrawal penalties, protection from creditors and legal judgments, required minimum distributions and possession of employer stock. Please view the Investor Alerts section of the FINRA website for additional information.
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
The target date of a target date fund may be a useful starting point in selecting a fund, but investors should not rely solely on the date when choosing a fund or deciding to remain invested in one. Investors should consider funds' asset allocation over the whole life of the fund. Often target date funds invest in other mutual funds and fees may be charged by both the target date fund and the underlying mutual funds. The principal value of these funds is not guaranteed at any time, including at the target date.
These examples are hypothetical only, and do not represent the actual performance of any particular investments. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and when sold or redeemed, you may receive more or less than originally invested.