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Leaving Your 401(k) Behind is NOT Like Leaving a Child Behind


A friend recently told me that she heard a financial planner once say that leaving your 401(k) at your old job was like leaving your kids behind when you move. This is not quite true. Below I will cover the pros and cons of each option you have when you're moving on. As long as you understand your choice, no need to feel guilty leaving a 401(k) behind!

Option #1 - Leave it where it is

This is a great option if your former employer has a good plan, with low cost investment options, and you have an account balance high enough that they will allow you to leave it there (some plans make you take it with you if your balance is, say, under $5000). Check your 401(k) documents or ask your HR person what the rules are during your exit interview process.

Pros:

  • No action to take on your part beyond keeping them aware of your address changes and periodically going in to check on your balance, rebalance your account, and update your beneficiaries.
  • No temptation of having money in your hands to rollover, then spending it, and ending up with taxes and penalties.

Cons:

  • More accounts to keep track of, and more places to notify if you move.
  • May have higher fees than other options.
  • Limited investment options.

Option #2 - Directly rolling it into your new employer plan

This is a great option if you like the simplicity of having all your employer plan funds in one account, and your new employer has good, low-cost investment options. The key to success with this option is doing a direct rollover. This is where your old plan writes a check to your new plan and you never see the money. Don't do an indirect rollover*. Just don't. Once you get information on your new plan and have an account, they can help you with a rollover.

Pros:

  • Simplicity once you complete the rollover.
  • No taxes and penalties due.

Cons:

  • Rollover paperwork.
  • Higher fees or more limited investment options than your old plan may have had.

Option #3 - Directly rolling it over into an IRA

This is a great option if neither your old plan nor your new plan has low fees and low-cost investment options. It also opens up a lot more investment choices that can allow you to diversity your portfolio. Search IRA rollover in Google and you will see how many companies want your business. Your bank may also offer IRAs.

Pros:

  • Virtually unlimited investment options.
  • Option to choose where to open your account.

Cons:

  • May have higher fees depending on the type of account you open, where you open it, and the kinds of investments you choose.
  • You will need to choose where to open your account - this choice is a pro and a con because many people will pick the company they just saw a commercial for on TV. IRA rollovers are big business in the financial services world. It's important to understand how the company is making money on your account - there is no free lunch.
  • You will need to choose your investments - with options come complications. If you're not the type who wants to spend time on this, you might need to hire someone who does. Make sure the person advising you doesn't stand to profit from the choices you make.

Option #4 - Cash it out

Cashing out small balances is not the end of the world, but you will pay taxes and penalties if you are under age 59 1/2. The employer is required to withhold 20% for taxes, but if you're in a higher bracket, then you will owe more when tax day comes, plus the 10% penalty. The other downside is that it's treated as income and can trigger nasty tax consequences.  The higher income that comes with higher cash out values could also impact every deduction and credit that flows from there on your tax return. This should only be a last resort.

Pros:

  • Cash, money, today. This is why lots of people do it.
  • Simplicity - nothing to rollover, nothing to care for in the future.

Cons

  • Taxes.
  • Penalties.
  • Nasty unplanned tax consequences.
  • Lost tax-deferred growth on those dollars.

As always, each individual situation will make one or more of these options more attractive than others. First compare your old employer plan to your new employer plan to understand the fees and investment options. Also, understand the special rules of your new plan such as loan or hardship withdrawal options. If you decide on an IRA, understand how the company you open it with gets paid and the fees associated with their investment options. Try not to cash out - a dollar you cash out today may only get you $.70 or less, but could lose you $10 in retirement!

 

*An indirect rollover is where your old plan sends you a check for 80% of the balance and sends the other 20% to the IRS. You have 60 days to put 100% of the balance into an IRA or your new employer's plan or it's just like cashing out. This is bad for 2 reasons: 1) you have to come up with cash for the other 20%, and 2) you're giving the IRS an interest free loan until you get it back after filing your taxes.