If you recently left a job where you were contributing to a 401(k) retirement plan, it can be all too easy to let the account sit for a while as you immerse yourself in new benefits and a new position. But it’s best to keep that money front of mind and be intentional with it. It’s yours and it’s your responsibility to manage it.
Four Options to Consider for Your Old 401(k)
Managing this money doesn’t have to be complicated. In fact, there are just four options for your old 401(k) funds:
Leave them in the old employer’s 401(k) plan
Roll them over to a new employer’s 401(k) plan
Roll them over to an individual retirement account (IRA)
Take the money out
In most cases, you’ll want to rule out the last option—taking the money out—if possible. It’s usually the worst decision except in the most desperate circumstances; please don’t do it unless you’ve thought carefully about the decision. When you take money out of a 401(k) plan, those funds are taxed as ordinary income, just as if you added that amount of money to your employment income for the year. This can result in a high tax bill. If you’re younger than 59 1/2 years old, it’s even worse: then you must also pay a penalty equal to 10% of the value of the money you take out of the plan. There are a couple of exceptions to these rules, but generally, it’s not a good idea to take money out of your 401(k) account unless you’re doing so deliberately as part of a well-thought-out plan or in the case of a true emergency.
Deciding between the other options requires analysis. In fact, if you’re working with an advisor, a new federal regulation actually requires this analysis. You or your advisor will need to consider several factors, including the quantity and quality of investment options available, the expenses of those investment options, the cost of the 401(k) plan or IRA account apart from investment expenses, the advantages of having all your accounts at one brokerage firm, the availability of professional investment management services, and the cost of those services, among others.
For example, if your old employer’s 401(k) plan has limited investment choices that won’t allow you to build a diversified portfolio, and those investment choices have high expenses, it might be better to move your 401(k) funds to an IRA account where you have access to nearly unlimited investment options, including many low-cost or no-cost options. Or, if your new employer’s 401(k) plan has a great list of low-cost investment options covering all the investment categories you need to build a complete portfolio (such as US large stocks, international stocks, emerging markets stocks, bonds, real estate, etc.), then you may want to move the money to your new employer’s 401(k) plan, if that’s allowed. (Not all 401[k] plans accept transfers from other 401[k] plans.)
Moving the money to an IRA account or a new employer 401(k) plan can help you better keep track of your money and be proactive in managing it. Many people find it convenient to consolidate their old 401(k) plan balances into a single IRA account by rolling over the money in their old 401(k) plan each time they switch jobs. Other people like to move their old 401(k) plan balances into their new employer 401(k) plan and consolidate their old 401(k) money that way. Either approach maintains the tax-deferred status of the money and allows you to manage everything in one place.
If you’re like many people, simply leaving the funds in your old 401(k) can lead you to ignore the account, causing the investments to perform poorly over the long-term. To streamline your life and make sure you give these critical retirement funds the care they need, lean toward consolidating your old 401(k) accounts in one place unless you have a good reason not to.
Push Versus Pull
Transferring funds from an old 401(k) account is different from other types of investment account transfers. When transferring brokerage accounts, the usual process is for the new brokerage firm to request the assets from the old brokerage firm, which then transfers the assets electronically. This is a “pull” type of transfer.
In contrast, 401(k) transfers work differently—they are a “push” transfer—and the language used can be confusing.
With a 401(k) transfer, you request what’s usually called a rollover distribution. The word rollover is important because it means you intend to move the money from one tax-deferred account to another tax-deferred account within the required time period, which maintains the tax-deferred status of the money. If the withdrawal is not completed as a rollover, it may be taxable. The word distribution is retirement plan jargon (which comes from federal tax law) for a withdrawal—when money is taken out of a retirement plan, there is said to be a distribution.
When transferring 401(k) account balances, you request a rollover distribution from the current 401(k) plan administrator, which can usually be done online but sometimes requires a phone call. You provide information about where you want the money to go, either to a rollover IRA account or to another 401(k) plan, and the administrator sends the funds. This is a “push” type of transaction. You need to take action to initiate the transfer by requesting the push transaction (a rollover distribution) from the 401(k) plan. Instructions for completing a rollover distribution are typically available online. For rollover distributions, you may be issued a check that you will need to deposit into your rollover IRA account. If you’re lucky, your 401(k) plan may be managed by the same company where you have your other brokerage accounts. For example, rollover distributions between 401(k) accounts managed by Fidelity Investments, a market share leader in 401(k) plans, and brokerage accounts at Fidelity Investments are easy and fast, and may only require making a short phone call or completing a brief online form.
Pre-Tax Contributions and Roth 401(k)
One more thing to be aware of when taking care of your old 401(k) is the different types of contributions you have made. Different types of contributions have different tax treatments.
For example, “regular” 401(k) contributions are pre-tax contributions. With this type of contribution, the amount you contribute from your paycheck reduces your taxable income—you don’t pay tax on that money before you put it into the 401(k) plan. You don’t pay tax on what the money earns inside the 401(k) plan either. Instead, you pay tax when you take the money out of the 401(k) plan later in retirement.
Another type of contribution is Roth 401(k). With this type of contribution, you pay income tax on the amount you contribute before you put it into the 401(k) plan. You don’t pay tax on what the money earns inside the 401(k) plan, and you don’t pay tax on the Roth 401(k) money you take out of the 401(k). Distributions are tax-free.
When you roll over your old 401(k) plan to a rollover IRA or new employer’s 401(k) plan, you have to match the type of money you contributed to the correct type of rollover account. For example, if you have both pre-tax and Roth contribution types in your 401(k) account, you can roll that money over to a pre-tax rollover IRA account and a Roth IRA account. It’s important to know what types of money are in your 401(k) so that your rollovers are completed correctly to preserve the correct tax treatment for each contribution type. The 401(k) plan administrator typically has checks in place to make sure this happens properly, but you should make sure it does—it’s your money, and you’ll pay the extra tax later if the contribution types get mixed up.
Making these decisions and following through on them may feel a bit tedious, which might be why old 401(k)s are one of the most commonly neglected accounts. But it’s important. You’ve got to decide the best way to manage that valuable retirement money as you keep moving forward, to make sure it keeps growing for you.
Don’t leave your old 401(k) behind without thoughtfully evaluating your options.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you would like help evaluating the best options for your old 401(k) accounts, schedule a complimentary consultation.
