Millennials have a knack for switching jobs throughout their careers. In our generation’s constant pursuit of workplace fulfillment, many suddenly find themselves one day with a collection of old employer retirement accounts. It’s kind of like unwittingly opening that random kitchen drawer only to discover a bursting assortment of koozies, collected from a couple of particularly busy wedding seasons and that one college alumni event that was somehow confident everyone in attendance would want 12 koozies each.
Naturally, a frequent question we get working with couples in their 30s and 40s is: “What should I do with my old 401k(s)?”
Whether you’re sitting on a stockpile and are uncertain of how to move forward (possibly the upcoming open enrollment season has reminded you of benefits past), or you’re preparing to make your first job switch and want to be prepared, this one’s for you!
You have FOUR Options
After separating from an employer, you can do one of four things with your old 401k:
- Leave the account where it is
- Roll it into a new employer plan
- Move it into an IRA
- Cash it out
Let’s break down each one and when they do (or don’t) make sense…
Option #1: Leave the old 401k where it is – with your former employer
This can be a good idea if…
- Your next job doesn’t offer a retirement plan, you are implementing (or planning to implement) a backdoor Roth IRA strategy, and the 401k in question contains pre-tax money.
- If your income is high enough to the point that the IRS says you cannot contribute directly to a Roth IRA, then you have to take the “backdoor” approach in order to put future dollars into a Roth IRA.
- This means you ALSO need to pay attention to what’s called the “pro rata rule”. In short, if you have any pre-tax dollars in an IRA and then go about doing a Roth conversion, you’ll end up owing some taxes (even if you only convert an amount equal to after-tax contributions). The solution? Keep pre-tax money in employer retirement plans since the pro rata rule excludes those accounts.
- The old plan has a great list of investment fund options and low expenses.
- Each company’s retirement plan has its own unique list of investment options available within the 401k. If the new plan is light on quality fund options and heavy on the fees, it may behoove you to keep that money put.
- You don’t have the next job lined up yet.
- There’s no need to rush into doing something with the old 401k. Wait until you have the next job secured to at least see how the new plan compares, so you can make the most informed decision.
- You want to take advantage of the Rule of 55.
- The Rule of 55 is a way for you to access retirement funds before age 59 ½ without owing that pesky 10% early withdrawal penalty to the IRS.
- To do this, you must be 55 or older and have separated from your company. This type of distribution can only be taken from your most recent employer’s 401k (or 403b), not an IRA.
- It’s important to note that not all 401k plans allow for this. While the IRS gives it the “ok”, the actual plan documents need to give it the green light as well.
- This method for early retirement money access comes with somewhat more flexibility than the Substantially Equal Periodic Payment (SEPP) route, which can be used with both 401ks and IRAs.
Be mindful that...
- You’ll be limited in how you can manage the account.
- You can no longer add new money to the old 401k. However, you WILL still have full control over how the money is invested (within the list of investment options the plan offers).
- More time and distance between you and a past employer can make it more difficult to access the account when needed.
- Just how solid is your system for keeping track of usernames and passwords?
- Your old company might decide to switch 401k providers, making the account more challenging to locate when you go back to hunt for it (“My account used to be held at Empower, but now it’s at Fidelity?? I’ve never even logged into Fidelity…”).
- If an especially long period of time passes, there’s even a chance the money could be transferred to the state as unclaimed property.
- If you have a smaller balance in the 401k, the plan administrator could take action on your behalf, without you requesting them to do so.
- For old 401k balances under $7,000, there’s a chance that the plan automatically does any one of the following:
- Cash out the balance and mail you a check, creating a taxable distribution (for balances under $1,000).
- Move the money into an IRA (also for balances under $1,000).
- Roll the funds into your new employer’s plan (sometimes for balances between $1,000 – $7,000).
- For old 401k balances under $7,000, there’s a chance that the plan automatically does any one of the following:
Option #2: Roll the old 401k into your new employer’s plan
This can be a good idea if...
- The new plan has a more robust investment fund lineup and/or lower fees.
- It may not necessarily make-or-break your ability to one day retire, but better-performing funds and lower internal expenses add up over growing balances and several years. So it could certainly help get you to your target more efficiently.
- The 401k has pre-tax dollars and you’re up against the pro rata rule.
- Just like we discussed in the section above, it’s essential to keep pre-tax money in employer retirement plans when you’re utilizing the backdoor Roth IRA strategy. That means either leaving your old 401k where it is, or rolling it over into your new employer’s plan – as long as the money doesn’t go into an IRA.
- You want to keep things as streamlined as possible.
- There’s a real benefit to simplicity. Even in the case where the new 401k plan isn’t a clear “winner” over the old one in terms of investment selection and/or expenses – if they’re pretty close – consolidating the accounts will probably make your life easier down the line.
Be mindful that...
- We’ll capture some of the things to be aware of here, and with the other options, in the “General questions and considerations” section at the bottom.
Option #3: Roll the old 401k into an IRA
This can be a good idea if…
- Your income is under the threshold that would prevent you from contributing directly to a Roth IRA.
- In the case that you have pre-tax dollars in a Traditional 401k, BUT your income is under the IRS limit for making direct Roth IRA contributions, then you’ll be in the clear of that annoying pro rata rule (assuming that a Roth IRA will also be part of your plan) since you’ll be able to simply make future contributions right into the Roth.
- Your entire 401k balance is made up of Roth money.
- If you don’t have any pre-tax funds in the 401k at all, then you don’t have to be cautious of this money sparking the pro rata rule when it gets moved into a Roth IRA. Again, it’s only pre-tax dollars in a Traditional IRA that make things tricky when doing the backdoor Roth IRA strategy down the line.
- Though increasingly rare these days, not all 401ks offer a Roth option. If that’s your new plan, then you’d have to go into a Roth IRA if you’re moving the money.
- You want more investment options and/or lower fees.
- By transferring the funds into an IRA, you’d then gain access to the full universe of investment options (mutual funds, ETFs, stocks, bonds, etc.). You can invest the money however you like, without being confined to a 401k plan’s set list of funds. This provides for greater control over the internal expenses that come with investments such as mutual funds and ETFs.
- With an IRA, you can also pick whatever custodian you prefer, and there are plenty that have no management fees.
- You are seeking professional investment management.
- Speaking of fees, professional management may or may not come with additional expenses, and it’s crucial to understand what those would be.
- However, if you’re the kind of person who values someone with the appropriate level of expertise taking on some of the responsibility with your retirement savings, you might consider an IRA to allow for this level of guidance.
- You want to do a Roth conversion.
- If you have pre-tax money in the 401k and you’re in a position where it makes sense to execute a Roth conversion, then this could be an easy time to make it happen. Of course, you’ll need to be prepared for any taxes owed on the conversion. Note that some plans do allow for in-plan Roth conversions, so this could be a possibility with a new 401k as well.
- You need some additional flexibility for penalty-free access of retirement funds for hardship or other life events.
- The IRS grants some leniency to early withdrawals from IRAs (over 401ks) under certain circumstances. You get an exception to the 10% early withdrawal penalty in the following scenarios:
- Up to $10,000 for a first-time home purchase
- Covering qualified higher education expenses
- Paying for health insurance while unemployed
- Still, income tax is owed on anything you take out and you should ideally treat retirement accounts as an absolute last resort for accessing funds earlier in life. Just because this is an option does not mean it is always a good idea.
- The IRS grants some leniency to early withdrawals from IRAs (over 401ks) under certain circumstances. You get an exception to the 10% early withdrawal penalty in the following scenarios:
Be mindful that...
- Roth money goes into a Roth, IRA and Traditional money goes into a Traditional IRA.
- If you have both “types” of dollars in your one 401k plan, you’ll have to split the money between two IRAs when it gets rolled over, based on the tax treatment.
- A “Rollover IRA” is essentially the same as a “Traditional IRA”.
- If you roll money from a 401k into an IRA, you will probably see the option to open a “Rollover IRA”. This account has the same tax treatment and contribution limits as a Traditional IRA. The IRS views these accounts through the same lens. You could choose to roll money from an employer plan into either one and you could then make contributions from earned income to either account. For all intents and purposes, the only real distinction is that you might opt for the “Rollover IRA” if you wanted to have some level of compartmentalization between retirement savings accumulated through past employers vs. those built up through your own contributions directly into a Traditional IRA.
- It’s worth emphasizing here, too, that money in a Rollover IRA is factored into the pro rata rule the same as money in a Traditional IRA!
- You need to actually invest the money.
- When the money is sent to your IRA from the 401k, it will come over as cash. It’s then on you to make sure it gets invested. This is a critical step.
- In many cases, you should be able to move money from an IRA into a current employer 401k plan if needed in the future.
- You’ll need to check with your current employer’s 401k plan documents to see if they allow for this “reverse rollover” (not all do).
- You can only transfer money from an IRA into the 401k of a company where you’re presently working.
- And why might you consider doing this? The most typical reason I come across is when your income has grown to the point of necessitating the backdoor Roth IRA strategy and we want to be sure you’re staying clear of issues with the pro rata rule.
- While the Rule of 55 exists for 401ks, Rule 72(t) (Substantially Equal Periodic Payments) is a way to access funds without the early withdrawal penalty from IRAs (and 401ks too).
- There’s a little less flexibility with how funds are accessed under this rule, specifically in regards to the amount and timeline of withdrawals.
Option #4: Cash out the 401k
Yes, technically an option… But not one you really want to give any thought to.
In short, don’t do it! By choosing to cash out your old 401k, you’re creating a fully taxable event (if it’s pre-tax money) and potentially exposing yourself to the 10% early withdrawal penalty if you’re below age 59 ½. Not to mention, you’re likely better off keeping those retirement savings invested and working toward your long-term financial security.
General considerations
- If you have an outstanding 401k loan….
- Upon separating from your employer, you’ll have a short period of time to pay back the full balance of the loan.
- If you don’t pay off the loan in the plan’s prescribed timeframe, the remaining amount owed is treated as a taxable distribution (which could also come with a 10% early withdrawal penalty if you’re younger than 59 ½).
- Choosing between a direct rollover vs. an indirect rollover…
- A “direct rollover” is one in which the 401k money is sent straight to the new IRA or 401k institution and never touches your hands. This is the easier and preferred method.
- With an “indirect rollover”, a check is sent to you. You then have up to 60 days to deposit the money with the new institution before taxes and penalties kick in. We recommend avoiding this type of rollover given the potential for taxes/penalty in the event it’s not handled in time, plus the increased chance of the check not making it to its appropriate destination.
- Take note of your vested balance…
- Your “vested” balance is how much of the account you can access or move, whereas the “unvested” balance is forfeited upon separating from your employer. The unvested portion won’t ever be accessible to you, regardless of what you do with the 401k.
- Understand the tax status of your 401k dollars (Pre-tax vs. Roth)…
- It’s important that the tax status of any new account you move 401k funds into matches the tax status the dollars had while in your 401k (Traditional → Traditional and Roth → Roth). You risk creating a taxable event if this gets mixed up.
- Be wary of the “advisor” who tells you that you have to move your old 401k into an IRA…
- As we’ve laid out here, your only option isn’t to move money from your 401k into an IRA. In fact, it very well may be in your best interest to leave it where it is or roll it into your new employer’s 401k.
- If you think you might have an old 401k sitting around somewhere, but aren’t sure…
- There are resources out there that can help you track down lost employer retirement plans. One such example is the Department of Labor’s Retirement Savings Lost and Found.
As for the koozies, your four options are:
- Make a quilt
- Develop a daily koozie rotation to justify the obscene number
- Decide which friends/organizations you love the most and toss the rest
- Dump the whole drawer and move on
Eddy Jurgielewicz, CFP® is a Partner and Lead Financial Planner at Upbeat Wealth, a fee-only firm based in New Orleans and serving clients virtually across the country. He specializes in providing straightforward financial guidance to ambitious young families as they navigate life’s many milestones.
Do you have questions about what we shared in this post, or anything else in general? Feel free to schedule a free consultation or drop us a line!
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