3 decisions to make with your 401(k) when you switch jobs
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You scored a new job at an awesome company, and it feels like you've won the lotto. In all the excitement of your last day, between the send off party and sad goodbyes, you scan your office for anything that you might've left behind – a cherished pencil holder, your stress ball, or that signed picture of Spider-man by Stan Lee.What about the 401(k) that you've been socking away money in each month? Should you take that with you too?
When you switch jobs, you've got three choices you can make with your 401(k):
You can leave it where it currently lives, in your old company’s plan.
You can roll it over to an Individual Retirement Account (IRA).
You can cash it out.
Each decision will have a different impact on your retirement goals and your tax return, so it’s important that you take all three choices into consideration before you make your move.
If you decide to leave your 401(k) with your old company, you don’t have to make any decisions with the plan at all. Your money will still grow tax-deferred, and unlike in an IRA, your 401(k) assets are typically protected from creditors’ claims. Your 401(k) will continue to grow thanks to a little thing called interest, but you won't be able to contribute any future money to your account.
This may seem like the simple decision to make, but it’s not always the most beneficial decision. Once you switch jobs, you’ll no longer have access to your Human Resources department that can help you with questions and guidance. It may also be hard to keep track of your 401(k) once you leave, so you’ll want to make sure you know who your 401(k) is being serviced by. Some of the most common plan administrators are names you might recognize – Fidelity, Vanguard, Schwab, and T. Rowe Price – however, there are loads of other servicers. You can find this out by asking your HR department for the details at your exit interview.
When you leave your 401(k) with your old company, there are a few things that could shortchange your balance. For starters, your old 401(k) may have higher fees and expenses than a new IRA. Fees in a retirement plan, called your expense ratio, can have a dramatic impact on your return over time. In other words, you could be losing money by keeping your 401(k) with your old employer versus rolling the balance over to a new IRA account.
Depending on how much you have in your 401(k), you might also have tax consequences that are out of your control. If you have less than $1,000 in your 401(k), your employer could cash out your plan, which would leave you owing a 10% penalty for early withdrawal plus ordinary income taxes on that amount. If you have under $5,000 in your 401(k), your old employer could move your 401(k) to a new IRA without prior notice or approval. In fact, over 57% of 401(k) plans with balances between $1,000 and $5,000 are transferred to an IRA by employers.
It’s critical that you update your contact information with your 401(k) plan administrator when you switch jobs. The plan administrator might have your old company work email on file, which of course won’t be operational when you leave your job. If your plan administrator can’t contact you easily, they might make a decision with your 401(k) proceeds that you aren’t happy with.
Interesting enough, only 22% of those ages 30-39 rolled over their 401(k) funds to either a new company's plan or a new IRA. Not all companies will allow you to roll over your old 401(k) into a new 401(k), so make sure you ask Human Resources at your new company if you’d like to pursue this path. There are some differences however between an IRA and 401(k); for example, you will likely have access to a wider array of investment choices and potentially lower fees with an IRA. These differences make a rollover a good choice for consideration.
First, you have two decisions to make with your rollover. You can either do what's called a direct rollover, or an indirect rollover, and which one you choose can have financial consequences
An indirect rollover is quite tricky and comes with a unique set of rules. You’ll be given a check for your 401(k) balance, and it's up to you to make sure the funds get deposited in the new IRA.
Here's the catch. When you request the indirect rollover, the company that is servicing your 401(k) will likely withhold 20% of your account balance for safe keeping. You, in turn, will need to come up with the missing 20% out of your pocket and add it your 401(k) check to make your balance whole. If you don't, the IRS could call the difference between your balance and the rollover amount a "cash out transaction", and thus you would owe a 10% penalty plus ordinary income taxes. Also, you have a quick 60 days to deposit your old 401(k) into a new account before the IRS deems the whole amount a cash out transaction. If you follow this process exactly as the rules stipulate, you will get the 20% returned to you when you file your tax return.The easier way is to do a direct rollover from your 401(k) administrator straight to your new IRA. This way, you never touch the money, and it appears in your new account seamlessly. With a direct rollover, you ensure that you won't be liable for any taxes or fees, and won't have a window for depositing the money because you're not involved in the transaction.
When rolling over to an IRA, you can either create a new IRA with many financial companies, such as Fidelity, Vanguard, Betterment, or Wealthfront. If you have an existing IRA, you can roll your old 401(k) directly into your IRA, and continue to do that as many times as you switch jobs. While you can’t take a loan from your IRA like you can a 401(k), you can take a withdrawal penalty-free for certain circumstances if you’re under 59 ½. Here are four of the most popular reason people withdraw funds from an IRA:
First-time homebuyers – You can withdraw up to $10,000 penalty free for your first home purchase. You'll still have to pay ordinary income tax on the withdrawal.
Education expenses – You can withdraw expenses for qualified higher education costs without a penalty.
Health insurance – If you’re unemployed or lose your job for more than 12 weeks, you can withdraw enough to pay for your health insurance for you, your spouse, and your dependents penalty free.
Disability – If you're disabled and need your funds to live, you can withdraw the money penalty free.
It’s estimated that 56% of Americans have less than $10,000 saved for retirement, and women are more likely than men to have little retirement savings. With little in retirement savings, you might be tempted to cash out of your 401(k) account and run away with those funds to someplace tropical. A word of caution: You won’t be able to leave with all that money.
When you cash out your 401(k) before age 59 ½, you’ll have a 10% penalty slapped on you, plus you’ll owe current income taxes on the full amount that you’ve withdrawn. That means that if you had $5,000 in your 401(k), you could owe up to 40% in taxes and fees. In fact, the average cash out amount for those under 40 is $14,300 in 2016, which could cause hefty fees and taxes that could be easily avoided by simply rolling over your 401(k) into an IRA.
Not only will you suffer tax consequences when you cash out, but you'll also lose the power of compound interest working in your account. Compound interest is simply the interest you earn on your original money plus the interest amount that you are accumulating. Think of it like interest growing on interest. Compounding interest allows your savings to grow much faster over time, and the longer you have to build compound interest, the better off you are.
If you’re thinking about cashing out of your 401(k), make sure you understand the consequences before you commit to the decision. You can’t undo a cash out after you’ve already given the ok; however, if you need the money, you need the money. You might be in a situation where you need the funds to pay for expenses before you start a new job, or perhaps you have to move to a new city and need to use some of the money to fund your move. While these are great reasons to cash out of your 401(k), you might find yourself in a situation where you haven’t saved an emergency fund and this cash is a valuable resource for you.Cashing out of your 401(k) is a decision that could have long-term consequences on your retirement savings. If you’re in a situation where you could really use the cash, try to look for other sources to come up with the funds rather than tapping your 401(k).
The next time you’re moving on to a new company, don’t forget to give your 401(k) some TLC. Deciding to leave your 401(k), roll it over into an IRA, or cash it out is an individual decision that you can make depending on your financial situation. There isn’t necessarily a right or wrong decision. However, you've spent years contributing your hard earned money to your 401(k). It's worth spending a few minutes to think through the next steps for your old 401(k).
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