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A question I hear almost every month is, “I have a balance at an old employer’s 401(k). What should I do with it?”
Wes Shannon
Like so many financial questions, the answer is another set of questions.
- How much is it?
- Do you have a 401(k) plan at your current employer?
- Do you have an Individual Retirement Account (IRA)?
- How old are you?
- When do you plan to use the money?
- Will you use it to retire or for some other reason?
Small amounts (less than $100,000) can be expensive to roll into a personal IRA because most firms will charge more than 1% or higher. (I’ve seen commissionable products charge 5%.)
The options are:
1. Withdraw the amount and pay the taxes and/or penalties;
2. Roll it into your current 401(k);
3. Roll it into an IRA (which even with the higher costs should be less than paying the taxes or penalties);
4. Leave it at the old plan.
I like options 2 or 4 for smaller amounts, unless you want to use the money now.
Larger amounts (over $100,000) have the same four options as smaller ones, but I tend to favor option 3.
Again, that assumes the money is not needed right now. A larger amount can still be rolled into a current 401(k) plan, but they also can be rolled over into a personal IRA. The advantage of an IRA is that the client gets to choose the investments. The administration costs of an IRA will usually be about the same as the former plan’s administration costs (give or take 0.25% — 0.50%).
With an IRA you have more flexibility, like trading in covered calls, cash covered puts, Exchange Traded Funds (ETF), mutual funds, or individual stocks and bonds. Within a 401(k) plan your investment choices are made for you by the plan administrators and generally they are limited to mutual funds and ETFs.
If you have a 401(k) plan at your current employer, rolling the old balance into the current plan gives you the advantage of having all of your money on one statement. While the investment choices in a 401(k) are limited, at least you do get to choose among the choices available. As stated above, this is a great option for small balances.
Several clients already have an IRA, so rolling the old balance into an existing IRA is a very good option. There is one technicality that should be remembered in order to allow the maximum flexibility: A “Traditional IRA” is one that was funded personally and not with employer sponsored retirement plans, while a “Rollover IRA” is one that is 100% funded with funds from an employer sponsored plan. Both types of IRAs can receive the funds from an old 401(k), but only a “Rollover IRA” can be rolled back into a 401(k) plan in the future.
If a person has left a company and had a balance in that company’s 401(k) plan but now has started their own business without a 401(k) plan, rolling the balance from the old company plan into a “Rollover IRA” will give them the option to roll it into a new business 401(k) plan in the future. If the balance was put into a “Traditional IRA,” they lose the option to move it into a 401(k) plan in the future.
The person’s age is also an important factor because withdrawals from 401(k) plans are subject to a 10% early withdrawal penalty for people under 59 1/2 years of age.
The withdrawal from the 401(k) plan is taxable (unless it was a Roth 401(k) plan). For example, a person with a $50,000 balance in a 20% tax bracket would have to pay $10,000 in taxes and the penalty would be an extra $2,000 if they were younger than 59 1/2.
If the money is needed now, taking the old balance out in cash would be an option. However, make sure there is a complete understanding of what the tax costs will be. Also, the withdrawal would be considered additional income and could cause the loss of income-based credits, increase Medicare premiums, or increase the amount of taxation on Social Security benefits.
As you can see, the simple question raises many additional questions and the answers can be complicated. Seek the professional advice of a Certified Financial Planner™ before making a decision.
Wes Shannon CFP® is a Certified Financial Planning Professional for Brazos Wealth Advisors.