Take it or leave it? Your 401k, that is!
The days of working for the same company for 40 years then retiring with a gold watch and a pension paid for life are long gone. Instead, we often hop from one company to the next, showing as little loyalty to our employers as our employers show to us. It's kind of like dating versus marriage. We "date" our employer as long as it is working for both of us, but neither will commit to a longer-term "marriage"-- through thick and thin--anymore.
Instead of a pension plan supplying a steady income stream in retirement, we are responsible for contributing to our company's 401k plan and making the correct investment choices that will ensure we have enough money to fund our retirement.
This new employment reality creates a dilemma each time we jump from one job to the next: What do I do with my 401k?
You have four options:
1."Cash it Out" This means paying the 10% penalty to the government if you're under age 59 1/2, as well as income tax on the amount. If your 401k has $10,000 and you're in the 25% tax bracket you'd pay $1,000 to Uncle Sam in penalties and $2,500 in additional income tax. That's right, if you cash out your $10,000 401k you'll be taking home only $6,500. On the other hand, if you keep it in a qualified retirement plan for another 30 years earning just 5% per year it will be worth $129,000! Of course, you'll still have to pay income tax when you withdraw the money, but I think you'll agree that cashing it out is never a good idea.
2."Rollover IRA" This means telling your plan provider that you want to have your 401k "rolled over" into an IRA at another institution, such as Vanguard, Schwab, Fidelity, or any other brokerage house. The advantage to this is you will have many more investment options than your current 401k offers.
One important thing to remember: Have your plan provider either wire the funds directly into your rollover IRA or send you a check for the amount made out to your IRA's custodian. If you have them send you a check made out to you the plan is required to withhold 20 percent for federal income taxes on the taxable portion of your distribution (you get credit for this withholding when you file your federal income tax return for the year). Unless you make up this 20 percent with out-of-pocket funds when you make your rollover deposit, the 20 percent withheld will be considered a taxable distribution, subject to any penalties and taxes explained above. Also, if you don't deposit the money in your rollover IRA account within 60 days the IRS will consider it all as a withdrawal.
3."Transfer to new 401k" This means telling your plan provider that you want to transfer it to your new employer's 401k (that is if your new plan allows it). The advantage to this is that your retirement funds will be consolidated at one place. If you like the investment options at your new employer's plan and their fees are reasonable, this may be a good option. Some companies require a person to work for a period of time before this option is available so you may need to keep your 401k at your old employer until you're eligible. Note: You may transfer money from one 401k to another, but not from an IRA to a 401k. Therefore, if you rollover your 401k into an IRA don't expect to later be able to transfer it into your new employer's 401k.
One other issue: This option could be best if you're considering doing a "back-door Roth" down the road. I'm not going to go into how this works here, but it's something you should be aware of.
4."Keep it where it is" If you like your plan's investment options and the fees are reasonable, this is the easiest option. Just don't forget that the account exists and make sure the provider always has updated contact information on you!
How do I determine if my 401k plan's fees are "reasonable"?
First of all you need to know what your plan's fees are. Fortunately, ERISA requires employers to disclose fees and expenses associated with 401ks. Just dig out that paperwork that you filed someplace or search for it on your most recent statement. There are three types of fees you need to be aware of:
1. plan administration fees-These are deducted from investment returns or show up as a flat fee.
2. investment fees-These are the largest fees, which you'll also encounter when investing at a brokerage house. They're deducted from investment returns as a percent of cash invested. There are three types of investment fees:
a) sales charges (loads or commissions)
b) management fees (investment advisor or account maintenance fees)
c) "other" (charged as a flat fee or percent of assets under management)
3. individual service fees for optional features, such as loans against your 401k account.
Now that you know what fees your 401k is charging, you have to compare the fees charged for all of your options to determine what is "reasonable". Find out what you'll be charged at your new employer's 401k and the fees on rollover IRA investments at a brokerage house.
As much as I tend to harp about the importance of low fees, they're just one factor in the decision making process. If your new employer has higher fees but better investment options, keeping your 401k at your old employer may not make sense. On the other hand, maybe your current employer's 401k fees are so much lower than IRAs that you're willing to give up the wider choices that IRAs offer for those fee savings.
As with most financial planning decisions, there's no "right" answer for everyone. It's a very personal choice dependent on each person's individual situation. I hope I've given you the information necessary to help you make the best choice for you!