Leave 401(k) or roll it over?
If you’re like most Americans, you change employers about as often as you change hairstyles.
Indeed, a 2012 report by the U.S. Labor Department notes that the average worker holds 11 jobs from age 18 to 46.
All that job-hopping may help broaden skill sets, but it also creates a dilemma for those who are unsure what to do with the 401(k) dollars they accrue.
Generally, you have four options when you leave your job:
Four 401(k) options after leaving a job
- Roll over the funds into an individual retirement account.
- Leave your 401(k) behind.
- Transfer the money to your new employer’s plan.
- Take the money and run.
That last option really isn’t a good choice, lest you sentence yourself to a lifetime of professional servitude. Nonetheless, many people take that route. According to a 2012 report by Transamerica Center for Retirement Studies, 25 percent of unemployed or underemployed workers cashed out their 401(k) plan.
Others used a wiser approach. According to the same report, 22 percent of people who left a job kept their 401(k) money where it was, and 20 percent rolled their accounts into an IRA.
Leaving money in an old 401(k)
Many retirement savers, especially those who are happy with the performance of their 401(k) plans, opt to leave the account balance with their former employer, at least for a while.
Despite the advice of some experts who favor the flexibility of an IRA, Pam Hess, an investment manager and former director of retirement research at Aon Hewitt, says many employees are better off leaving their money in a defined contribution plan — either their former 401(k) or their new one.
“Generally, the benefits of leaving your retirement money within a defined contribution plan are superior to rolling them over to an IRA,” she says. “You have the purchasing power of the entire plan behind you rather than being out there on your own.”
- If your account holds less than $1,000, your employer is allowed to automatically cash out your account when you leave.
- If your account holds between $1,000 and $5,000, most employers will automatically roll your 401(k) into an IRA when you leave your job.
- If your account holds more than $5,000, you must decide whether to leave your money behind or take it with you.
Indeed, mutual funds affiliated with 401(k) plans typically waive load fees for plan participants and transaction costs for 401(k) investors can be lower. Meanwhile, IRAs frequently charge an annual (though nominal) maintenance fee.
However, the savings of a 401(k) plan can be wiped out if an employer-based plan offers mutual funds that charge high fees. So, for example, it’s important to understand all the expenses of your company plan before deciding whether to keep the money in your 401(k) or roll it over into an IRA with a provider of low-fee index mutual funds.
For those nearing retirement, Hess notes there may be an added incentive for leaving your funds in a 401(k) — especially if you expect to begin tapping your nest egg before age 59 1/2. That’s because the IRS allows retirees to begin penalty-free withdrawals from their 401(k) accounts beginning at age 55.
Typically, if you withdraw money from your IRA before age 59 1/2, you’ll pay ordinary income tax plus a 10 percent penalty.
Rolling over your money
However, there are also potential drawbacks to leaving your money in an old 401(k). As mentioned previously, some 401(k) plans offer mutual funds that charge high fees, which can eat into your returns over time and leave you with less money once you retire.
Another drawback to leaving your 401(k) money with former employers is that you can easily accumulate a half-dozen accounts by the time you reach retirement.
That makes managing your portfolio tough.
Another disadvantage is their lack of flexibility — the vast majority of 401(k) plans restrict investors to mutual funds and company stock.
That’s where IRAs come in.
Both traditional and Roth IRAs offer a wide variety of funds, individual stocks, bonds and certificates of deposit from which to choose.
“The fact that you can essentially invest in almost anything is a major benefit with IRAs,” says Nick Kaster, senior analyst at Wolters Kluwer. “With 401(k)s you’re limited to investments that your employer provides and, in some cases, they may not be good.”
Those who opt to directly roll their fund into a traditional IRA via a trustee-to-trustee transfer pay no upfront taxes, although they will pay tax on their withdrawals during retirement.
Those who roll over into a Roth pay their taxes upfront, but the earnings grow tax-free.
Roths are often recommended for younger employees with lower incomes, who may choose to pay taxes on their contributions today and enjoy tax-free withdrawals down the road.
They are also well-suited for those who may need early withdrawals for non-retirement related expenses.
The Internal Revenue Service allows retirement savers under age 59 1/2 to withdraw the earnings portion of their Roth IRA penalty-free as long as the account has been open at least five years and the money is used for qualified expenses, including the purchase of a first home, higher education or medical cost. The original after-tax contribution to a Roth — your principal — can be withdrawn without penalty at any time for any reason.
The contribution amount allowed for Roth IRAs, however, begins to phase out for joint filers with incomes exceeding $181,000 in 2014, and for singles and heads of household with incomes exceeding $114,000.
Whatever IRA you choose, remember to instruct your employer to complete a “direct rollover,” where your money gets moved from your 401(k) to your IRA without touching your hands.
Withdrawing the money yourself would be viewed as a cash distribution, and taxed and penalized accordingly.