401K rollover

What to do with Your 401k When Leaving a Job?

So you’ve been working on building your 401K, and taking advantage of that nice juicy employer match.  But alas, a better opportunity came along so you changed jobs (or quit or retire).  So what should you do with your old 401k?

What Should You Do With Your Old 401k?

If your new employer also has a 401K, you have four options (and if not, you still have the first three which also apply if you quit or retire):

  1.  Take the money and run.
  2.  Leave the money in your old 401K.
  3.  Rollover the money to an IRA.
  4.  Rollover the money to your new 401K.

The first option is almost always a bad idea for many reasons.  You will likely incur unexpected taxes, and you may get bumped up into a higher tax bracket.  Yuck.  Depending on your age, you may also face penalties.  Double yuck.  Anyway, if you are reading posts on FIDough Hub (a site focused on the financial independence retire early movement, aka FIRE) you almost certainly are interested in the other three options.

Other things being equal (which often is not the case), we believe (and others disagree) that the best option is #4 – rollover the money to your new 401K or #2 – leave the money in your old 401K.  But hey, details matter so let’s get right to it and start with some of the basics.

What are the Differences Between 401Ks and IRAs?

To help determine the best option for your particular situation, it helps to understand some of the similarities and differences between 401Ks and IRAs.

Similarities

  • Both types of accounts allow you to grow your investments tax free.
  • Both often have ROTH and non-ROTH versions.
  • Both also offer some creditor protection (but the 401K protection is better).

Differences

  • IRAs generally have more investment options. Most 401Ks allow employees to select from a comparatively small universe of investment options. IRAs give an investor access to thousands of choices: mutual funds, ETFs, individual stocks and bonds, etc.
  • IRAs often have lower fees. Low-cost index investing is all the rage currently, and IRAs make such investing easy.
  • 401Ks have better creditor protection.Although a rollover IRA will generally provide some bankruptcy protection, 401K plans (and other employer sponsored plans like 403(b)s) generally have exceptionally strong creditor protection inside and outside the bankruptcy context.  Federal law protects 401(k)s from virtually all types of creditor judgments bankruptcy or not (other than IRS tax liens and possibly, spousal or child support orders). So hands down, 401Ks win on the creditor protection front.
  • 401Ks provide better early retirement options. 401ks (and 403(b)s) also generally allow for withdrawals if you retire from your employment at age 55.  With an IRA, you have to wait until 591/2. So with a 401K you have the option to retire early and take advantage of your 401K without paying the steep 10%penalty you would for an early IRA withdrawal.
  • 401Ks allow you to delay RMDs. If you are still working when you turn 70 1/2., you can also delay taking the required minimum distribution (RMD) from your 401K.  In an IRA, you must started taking the RMD even if you are still working.
  • 401Ks generally allow you to borrow from the account.You may also generally borrow from your 401K (check your plan to confirm), but not your IRA.  Although generally not recommended, this option could be nice in certain circumstances.
  • 401Ks sometimes give you access to institutional class funds for lower fees.Lastly, the better 401K’s may give you access to institutional class funds at lower rates – funds not available to you (or available at the same cost) in an IRA.  Given the wonderful options available in IRAs, this may not be the advantage it once was.  But it is a difference.

The 401K Rollover Options

With that general background, let’s explore the options, starting with leaving your money in your old 401K.

Leave the Money in Your Old (Former Employer) 401K

Certainly nothing could be easier than leaving the money in your old 401K.  And, there is much to be said about simplicity.  Furthermore, if your old 401K has better options than your new 401K (i.e., low cost ETFs or index funds), that might weigh in favor of not rolling over your money.

But some employers charge former employees higher fees.  If your balance is too low, you may be kicked out anyway.  You are also stuck with the investment options offered by your former employer (which may be good or bad).  You may also not borrow money left in the former company’s plan.  Lastly, you may also lose track of the account (but not if you use Personal Capital!).

Pros of old 401K

  • It’s simple and easy. If you do nothing, this is the likely outcome (unless your balance is below a threshold minimum).
  • You get most, but not all, of the benefits of a 401K (e.g., better asset protection, access to institutional funds, etc.)

Cons of old 401K

  • Your former employer may charge you more as an ex-employee.
  • You may forget about the account (unless you use something like Personal Capital).
  • Your investment options are limited to the funds offered in the old 401K.
  • You cannot borrow from your old 401K.

Rollover the Money Into an IRA

As noted at the outset, many financial planners recommend rolling over your old 401K into an IRA.  Such an option certainly gives you access to a wide variety of low cost investment options, and makes developing a diversified portfolio a snap.  The account also has no connection to your job, so if you change jobs again you need not worry about losing the account.  You can keep track of it simply by updating your mailing address if you move.  If you change jobs again, you could rollover another 401K to this account to help simplify your life. So lots of plusses on the simplicity side.

But this “simple” option comes with a price. If your current or former 401K had good options available only to 401K plans, you will lose those options.  You also will not be able to borrow from your IRA rollover.  You will lose the better asset protection available with a 401K.

Moreover, the main reason many investment advisors like IRA rollovers – the “better” investment options – often no longer holds water.  Increasingly employers are offering better 401K options.  Many employers now use companies like Vanguard, Schwab and Fidelity, which offer many great options.  In many Schwab plans, for example, one may opt into a “personal choice” account for free.  In that account, one may invest in virtually any ETF, stock, bond, mutual fund, etc.  Depending on the plan, there may be some limits (e.g., many preclude commodities trading).  But in any event one could not complain about the wide variety of truly great low-cost investment options.

There are also no 401K plans that automatically invest your assets if you do nothing.  Schwab, for exmaple, has plans that will automatically put together a balanced portfolio of super low-cost ETFs based on your age, income, and other factors for a very low fee – just like the best robo advisors.  In short, you may already have a truly great 401K plan that bests most IRAs so look into it before making any decisions.

Also, if you own actual shares of your former employer’s stock in your 401K (as opposed to a fund that is set up to mimic the company’s stock performance) , rolling that stock into an IRA may ultimately cost you a lot more in taxes.  (Skip to the next section if this is not an issue for you.)  This detail goes beyond the scope of this article, but as explained here, if you find yourself in this situation a better option may be to roll over company stock to a regular brokerage account at the appropriate time.  Lots of caveats here, but know that company stock creates a trap for IRA rollovers.

Pros of IRA Rollover

  • With companies like Schwab, Fidelity, Vanguard and others you get access to a wide variety of great low-cost ETFs and index funds (and some good managed funds too).
  • The account will follow you without regard to your current employer (just don’t forget to update your address info. if you move).
  • You can use the account rollover your next 401k if you change jobs in the future.
  • In sum, a simple, flexible solution.

Cons of IRA Rollover

  • You may give up access to some of the institutional funds available only to large employer buyers.
  • You cannot take a loan out on the account.
  • You will lose the better asset protection available with a 401K
  • Creates a tax trap if you own actual shares of company stock in your 401K

Rollover the Old 401K to Your New 401K

Lastly, you can rollover your old 401K to your new 401K.  This option brings you all of the advantages of a 401K (better asset protection, early retirement options, loan options, etc.).  Moreover, it avoids the problem of losing track of an old 401K.

If your new employer is a fairly large employer, your new 401K plan may be rated on Brightscope.  Unfortunately, Brightscope limits the full 401K detail to advisors, you will be able to see a comparative ranking for free.

You may also, for free, check your 401K’s offerings on Morningstar.  Type the mutual fund/ETF ticker you are interested in in the “Quote” box at the top of Morningstar (e.g., DODGX), and you will see the pertinent expenses.  You will also usually see whether Morningstar considers the “Fee Level” “Low” (or not).  If your 401K does not provide some good choices with fees less than 1%, you unfortunately do not have a good 401K plan.  In that case, go complain to your company’s 401K committee.  They can do better, much better.  And these days, companies that still offer employee’s crummy choices are getting sued so speaking up may pay off.

Morningstar also provides a lot of other information for free, and with its premium service you can review analyst reports on many funds/ETFs.

Pros of New 401K Rollover

  • Better creditor protection than IRAs
  • The potential to take money out as early as age 55 without penalties.
  • The potential to delay RMDs if you keep working past age 70 ½.
  • The option to borrow money from your account.
  • Potential access to institutional class funds for low fees.

Cons of New 401K Rollover

  • You are limited to the investment options in your plan (which may or may not be a true negative).

How to decide whether to rollover your 401K to an IRA or Your New Employer’s 401K

With this background, you should be able to determine which option is best for your own situation by asking these questions.

  1. Which option will make it easiest for me to create a low-fee/cost diversified portfolio, i.e., good options with fees less (ideally a lot less) than 1%?
  1. Do I care about creditor protection? (We think everyone should because you never know what might happen, but for some this is a bigger issue than others).
  1. Is the early retirement option with a 401K something I might use?
  1. Do I think I might work past 70 ½ and want to delay RMDs?
  1. Does the convenience of fewer accounts matter?
  1. Might you lose track of your old 401K?

If your new 401K has a good selection of low cost funds/ETFs, that is likely your best option.  If not, you then must weigh the other factors to decide whether you are better off leaving the money in your olf 401K or simply rolling it over to an IRA.

The Mechanics of the Rollover Transaction

If you decide to roll over an old account, contact the 401(k) administrator at your new company for a new account address.  Typically this looks something like “ABC Company 401(k) Plan FBO (for the benefit of) Lisa Smith.”  Provide this information to your old employer, and the money will be transferred directly to the new plan (or sometimes sent to you by check made payable to the new account address).  If you get a check, give it to the new company’s 401(k) administrator ASAP. This rollover method is called a direct rollover. There are other methods, but a direct rollover is the simplest method and it ensures you will avoid taxes and penalties.

You can (and should) also use a direct rollover method if you decide to rollover to an IRA.  In that case, contact the IRA provider for the necessary info.

Put Your Rollover Plan Into Action & Keep Saving

Now that you have the information necessary to decide what to do with your old 401K, put your plan into action.  And, of course, take advantage of that company match, and ideally max out your contribution.  And, if you are  a true all-star saver, front-load your savings each year by putting up to 100% of your pay check into your 401K until you hit the limits.  Investing early and enough pays huge dividends over time because the stock market tends to goes up over time, and historically has gone up on average two out of every three years.

Note too that the rules concerning IRAs/401Ks and other plans sometimes change, so make sure you have the current information.  Believe it or not, the IRS actually has some decent resources to help with this at https://www.irs.gov/retirement-plans.

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