BlogWhat to do With Your Old 401k
Posted about 2 months ago

What to do With Your Old 401k

The investment landscape is littered with old 401k accounts.

Let’s talk about something many of us are guilty of: leaving behind old 401k accounts like forgotten toys from our childhood. Ever worked at a company, diligently set aside a portion of your paycheck into a 401k, and then moved on to greener pastures, leaving your 401k to fend for itself? If you’re nodding your head, you’re not alone. It’s easy to think, “Hey, it’s still in the market, growing, so why bother?” But is that the best approach? Let’s dive into the world of forgotten 401ks, unravel the mystery, and empower you to make informed decisions about your hard-earned money.

Leaving Your 401k Where it is

Many companies will allow you to keep your old 401k account open and active. After all, it looks better for them to have more assets on their books since they get to charge on those assets.

Sometimes there will be minimum account balances, usually set at $1,000 or $5,000. If you are below those minimums and leave your job, they will most likely close the account and send you the money. If you are above those minimums, there is a good chance that you can just leave the money in your account.

The main reason to leave the money in your old 401k is if you are over the age of 55. There is a little-known rule that allows you to take money out of a 401k penalty-free if you separate from service (quit your job) in, or after, the year you turn 55 years old.

Normally, you would have to wait until you are 59.5 years old before you can take money out of a retirement account to avoid the penalties. The normal penalty is 10% of the money you take out, so you can see why it would be a good idea to avoid this. This separate-from-service rule is a great way to access your retirement funds at an earlier age.

This is extremely helpful if you are retiring early (before the age of 59.5), and all your money is tied up in retirement accounts.

A neat trick to use to take advantage of this rule is to roll additional retirement accounts into this 401k before you separate from service.

Let’s say you have money in your 401k, but the majority of your retirement funds are in your IRA (Individual Retirement Account). You plan on retiring at 55 and would like to have access to your retirement funds. If your 401k plan allows (and many do), you can roll your IRA into your 401k, separate from service, and then have access to all of the money penalty-free.

But what if you are not 55, retiring early, or need access to this money?

Does it still make sense to leave the money in your old 401k account?

The fact is, you may be very comfortable with your old 401k account and not yet ready to make that break-up.

You could be very familiar, and happy with, the 401k plan website and service team that has helped you inside the plan, and not ready to give that up. A lot of 401k plans could have some extra bells and whistles that you’ve grown accustomed to, such as retirement calculators, net worth trackers, or educational content.

As you know by now, 401k’s can be very limited in their investment options. If you have a 401k where you are happy with the investment options, it could be a good reason to stay. This is especially true if your new 401k has a more limited, or less ideal, investment lineup. The 401ks at larger companies usually give you access to institutional shares or classes of funds, which can come at a lower cost than you can find in the normal market. It can also offer investment options that you cannot get yourself outside of the 401k, because there may be large minimums attached to those investments.

The two biggest factors you should consider when deciding whether or not to leave your old 401k are the separate from service at 55 rule and the fees being charged in the 401k plan. 401k plans, and other employer retirement plans, are notorious for being high in fees.

What makes it worse is that these fees are typically hidden in the plan documents that no one really looks at.

Most people are familiar with an investment’s expense ratio. This fee is usually the one that is very present in the investment lineup and can be easily spotted. This is not the only fee – and far from it – that goes into a 401k plan. This is just the fee for the fund company to manage those investments; you also have a recordkeeper fee and a third-party administrator fee. You may also have an advisor fee that helps to oversee the plan. All these fees will be laid out in the summary plan documents (SPD). Every fee you pay is less of a return your money makes for you. Accumulate that over your working career, and you can have a big drag on your return and retirement funds.

Beyond looking at the normal investment and management fees, you also want to look at the other miscellaneous fees. A lot of 401ks will have fees for taking money out of the account, so if you are withdrawing money regularly from the account, make sure to watch that fee.

One of the big downsides to leaving money at an old 401k is that you begin to spread your financial assets out over multiple custodians. It may seem like a good idea to diversify, but in reality, it can make things more difficult.

If your employer goes out of business or makes a lot of big changes, it can be difficult to locate your old 401k. This is especially true if you also move and don’t update your contact information with the old 401k plan.

Old, abandoned plans where they can’t track down the owners is such a common problem that the Department of Labor has built a database for it.

The absolute worst thing that could happen is that the old retirement plan gets dissolved. When this happens, they will try to contact you, but if they cannot reach you then the money could be sent to the state as unclaimed property. You probably won’t find this out until you get tax forms in the mail saying that you took a distribution from the account, and you owe penalties and taxes. Now, there is a way to avoid those penalties and taxes, but the hassle of trying to track down the money, get it back, roll it into a new retirement account, and then deal with the IRS can be burdensome.

The money could also be sent to the state, even if the plan hasn’t been dissolved. In rare and unusual cases, the plan administrator will deem your account to have gone dormant because you haven’t logged into the account or called upon it, so they will simply say that the account is unclaimed and send it to the state. This is a rare case, but it does happen.

Consolidating Savings: Transferring from Old to New 401k

If you’ve decided that you would rather not leave your old 401k behind, you do have the option of rolling it into your new 401k plan. Maybe your new plan has all the things that we really want in an employer retirement plan, like good investment options, low fees, a stunning website, and additional features. If this is true, then you can simply roll the old account into the new account.

With an old 401k plan, you must push the money out of the old plan and into the new one. That simply means that you need to talk to your old 401k provider, fill out their paperwork, and then they will transfer the money into the new plan. You will not be able to pull the money into your new plan by speaking with your new 401k provider, as it must be done through the old provider.

The type of transfer you are looking for is a direct transfer, also known as a trustee-to-trustee transfer. A direct transfer will transfer the money directly to your new 401k plan. The old 401k will make the check out to the new 401k plan, so the money will move directly into that account. There is a good chance that the old 401k will still send you that check, but if that happens then you simply just send it to the new 401k. You do not need to cash it or sign it. It will be made out to your new account, and they just need you to forward it to the new account. Think of it as a way for the old 401k to cover themselves by making sure that you get the check, and they don’t have to worry about the new company getting it.

Once you get the check, we recommend sending it overnight priority with tracking numbers. If the process is done this way, you will have very little to worry about. If the check gets lost in the mail, the old 401k company can simply put a stop order on the check and issue a new one. This is why it is a good idea to make sure the checks are sent priority and overnight.

If you do a direct transfer from the account, you will also not have to worry about penalties, deadlines, or tax withholding.

This is an important note: since the check will be made out to your new account, you will not be able to cash it in your bank (which is a good thing). For this reason, you do not have to worry about incurring the 10% penalty for having the money taken out of your 401k plan.

Typically, when you pull money out of a 401k plan, they are going to send 20% to the government for tax withholding. This can be a real issue if you are trying to roll the money into a new account because the government will see that 20% withheld as a distribution and charge you tax and penalty on it.

For example, you take the money out of your old 401k with the intention of rolling it into your new 401k without a direct transfer.

The amount you take out is $100,000, but the old 401k company sends 20% (or $20,000) to the IRS. You roll the remaining $80,000 into your new 401k plan. The IRS will see the missing $20,000 and charge you taxes on that money, plus a 10% penalty ($2,000) for the distribution, even though that money was sent to the IRS.

This is known as an indirect rollover, and it is just a hassle, so try to avoid doing it that way at all costs.

This can all be avoided if you simply do a direct, or trustee-to-trustee, transfer from one account to the next. The company will not send any money to the IRS, and the distribution will be for the full amount, which means you have nothing to worry about.

Before you go through all this trouble, it is a good idea to double-check and make sure that your new 401k will allow you to roll the money into the plan. I have never seen a plan that doesn’t allow it, but I am sure there is one out there.

Roll Your Money into an IRA

Another solution that you could adopt is to roll your old 401k into an IRA (Individual Retirement Account). IRAs are good retirement accounts in that they are easy to manage, low cost, and give a wide range of investment options. Your IRA also maintains the same tax structure as your old 401k did.

You will need to start the IRA account on your own at a custodian or brokerage house. Once the account has been set up, you would do a direct, or trustee-to-trustee, transfer, but instead of putting money into a new 401k, you would give them your IRA information.

Once the money is in an IRA, you have an almost unlimited amount of investment options. You can invest in individual stocks, exchange-traded funds, and exchange mutual funds. It is almost unlimited because you cannot use that money to invest in real estate, small businesses, or collectibles, but anything traded on the stock market is fair game.

There are no real additional fees that come with investing money into an IRA account. You will have the fee to make the trade, which is around $0 at most brokerages, and the expense ratio if you invest in a fund. Most brokerages do not charge a fee to hold the account open, or any kind of recordkeeping or administrator fee. From a cost standpoint, an IRA cannot be beat.

An IRA is also a good place to continually store your retirement accounts. If you have multiple IRA accounts, you can roll them all into one account for easier management. If you have multiple old 401k accounts, you do not need a new IRA account for each, and you can combine all of them into one new IRA account or one IRA account that you already have. This is a great way to simplify your financial assets and retirement accounts by giving you one place to manage everything.

The biggest downside to using an IRA is that it’s a lot more to self-manage. There are no set investment options or somebody watching over you to make sure you don’t mess it up. You can easily overfund the account if you are not careful. Please not that you cannot overfund the account by doing a rollover of your old 401k into the account, only when adding new contributions into the account at a later time.

You will also have to pick and monitor your own investments. There is not a target date-fund or default investment that you can choose to invest in that will manage your money for you. You will need to select your investments and manage those investments over time. This can be very daunting since there are 5,000+ investment options to choose from. What typically happens is that a person will roll that money into an IRA and then leave it in cash, because they are not sure what to invest in. This is obviously not a good solution, because money out of the market is typically a losing position.

The Last Resort: Liquidating Your 401k

The extreme solution to manage your old 401k is to simply cash out. Take a full distribution from the account, and they will send you a check to put in your bank account. If you take a distribution from the account, you will have to pay taxes, and maybe penalties, on that amount. The distributed amount will be considered ordinary income, so you will pay your normal tax rate on that amount.

As we mentioned earlier, the 401k provider will automatically take 20% out of the amount and send that to the IRS. The IRS always wants their cut of the money before you can spend it all.

If you are under 59.5 years old (55 if using the separate from service rule), you will also pay a 10% penalty on the amount of money distributed.

The 10% penalty will be based on the total amount, so that includes any amount (20%) that gets sent to the IRS. The penalty will not be assessed until you file your taxes, so you will need to be aware of that surprise come time to file.

Cashing out a 401k should only be left as a last resort when you absolutely need money. It will be able to solve the short-term cash issue, but it will also create long-lasting negative effects on your finances. The 10% penalty reduction, along with losing the ability to grow the money in a tax-deferred account, is a great challenge to overcome.

Obviously, desperate times can call for desperate measures, but please make sure that this a tactic of last resort.

One thing to note on financial hardship is if you are debating on taking money out of your 401k or declaring bankruptcy, then it may be better to declare bankruptcy. Money in retirement accounts, such as 401ks, are shielded from bankruptcy, which allows you to keep your retirement funds intact. What you do not want to do is pull all the money out and still declare bankruptcy after it is all gone. You will then be left with no retirement and no financial assets.

Steps to Manage Your Old 401k

1.  Evaluate Your Current Situation:

  • Review all 401k accounts from previous employers.
  • Identify current balances, investment options, and fees associated with each account.

2. Decide Whether to Leave Your Old 401k Where It Is:

  • Review the fees associated with your old 401k account. This includes management fees, advisor fees, and other miscellaneous fees.
  • Compare the investment options available in your old 401k with other potential accounts.
  • If you’re nearing or above the age of 55, consider the “separate from service” rule and how it might benefit you.

3. Rolling Your Old 401k to Your New 401k:

  • Contact your previous employer or the 401k plan administrator and inquire about the direct transfer process.
  • Fill out any necessary paperwork for the trustee-to-trustee transfer.
  • Ensure your new employer’s 401k plan accepts transfers.
  • Track the transfer to ensure it’s completed seamlessly and within any given timelines.

4. Roll Your Money into an IRA:

  • Choose a reliable brokerage or financial institution to open an IRA.
  • Initiate a trustee-to-trustee transfer to move funds from your old 401k to the IRA.
  • Research and select investment options within the IRA. Consider diversifying your portfolio based on your risk tolerance and financial goals.
  • Regularly review and adjust your portfolio as needed.

5. Avoid Cashing Out Early (If Possible):

  • Understand the tax implications and penalties of cashing out your 401k before the age of 59.5.
  • Consider other options like rolling over the 401k to avoid early withdrawal penalties.

6. Stay Organized:

  • Update contact information with your old 401k providers, especially if you move.
  • Periodically check in on old accounts to ensure they aren’t considered “abandoned.”
  • Utilize the Department of Labor’s database for abandoned plans if you lose track of an account.

7. Keep Updated on Regulations and Rules:

  • Tax laws and retirement account regulations can change. Stay informed about any changes that might affect your decisions related to 401k accounts.

8. Set Calendar Reminders:

  • Schedule periodic reviews of your retirement accounts, including asset allocation and performance. This will help you stay proactive and adjust as needed for optimal growth.

9. Educate Yourself:

  • Spend time understanding the basics of investing, tax implications, and retirement planning. The more informed you are, the better financial decisions you’ll make.

Conclusion

401k accounts are pivotal tools for securing a comfortable retirement. Whether you choose to leave your old 401k intact, roll it into a new one, or transfer it to an IRA largely depends on your financial situation, age, and retirement goals. However, cashing out should be a last resort. It’s essential to regularly review and manage your 401k, just like any other financial asset, to ensure it aligns with your evolving life goals. And remember, taking control of your 401k means taking control of your financial future. Don’t let forgotten accounts hinder the growth of your hard-earned savings. Instead, be proactive, informed, and diligent in managing your retirement funds.

Glossary

401k Account: A tax-advantaged retirement savings account offered by many employers. Employees can contribute a portion of their salaries to these accounts.

IRA (Individual Retirement Account): A tax-advantaged investing tool that individuals use to earmark funds for retirement savings.

Direct Transfer: The process of moving funds from one financial institution to another without the funds being payable to the account holder.

Trustee-to-Trustee Transfer: A method of transferring funds from one retirement account to another without the account holder ever gaining control or use of the funds, ensuring no penalties or tax withholdings.

Portfolio: A collection of financial investments like stocks, bonds, cash equivalents, mutual funds, and other assets.

Diversifying: The strategy of spreading investments among different types of assets or sectors to reduce risk.

Risk Tolerance: An individual’s willingness and ability to endure swings in the value of their investments.

Early Withdrawal Penalty: A penalty charged for taking money out of a retirement account before a certain age (typically 59.5).

“Separate from Service” Rule: A rule that applies if an individual leaves their job, either voluntarily or involuntarily, during or after the year they turn 55. They can then take withdrawals from their 401k without the typical 10% penalty.

Abandoned Plans: Retirement plans that have been left without oversight, typically because an employer goes out of business or is unresponsive.

Asset Allocation: An investment strategy that involves deciding how to distribute your investments among various classes like stocks, bonds, and cash.

Tax-advantaged: Financial accounts that offer tax benefits, such as tax deductions or tax-free growth, typically provided for retirement savings or education expenses.

Published in Member Blogs, Uncategorized

Comments