If you're leaving your job for any reason, you probably have a lot on your mind. You're focused on learning a new job or finding a way to replace your paycheck. It's understandable that figuring out what to do with your 401(k) often isn't your top priority.
But when you part ways with an employer, you have some big decisions to make about your old 401(k) plan. Here are five mistakes to avoid -- and what to do instead.
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1. Leaving a small balance with your old employer
Most employers will allow you to keep your money in their 401(k) plan even after you've left the company. But if your balance is less than $1,000, some employers will send you a check -- and if you don't reinvest the money in your individual retirement account (IRA) or a new employer's retirement plan, you'll get hit with taxes, plus a 10% early withdrawal penalty if you're younger than 59 1/2.
If your balance is between $1,000 and $5,000, some employers will move your money into what's known as a safe harbor IRA. Your money will be invested ultra-conservatively -- about 76% of such IRAs are invested in money market mutual funds, which often don't earn much more than a high-yield savings account.
Always check with your plan administrator about the rules for your 401(k) before switching jobs. If your employer forces low-balance accounts out of their plan, be sure to roll over your money into an IRA or a new 401(k).
2. Letting your old employer send you the money
When you roll over your 401(k) into your IRA or a new workplace plan, be sure to verify that the plan administrator is doing a direct rollover. That means they'll send the check directly to your new financial institution, rather than to you.
If you do an indirect rollover, which means the check is made out to you, your old employer will have to automatically withhold 20% for taxes. On top of that, if you don't reinvest the entire amount in a new retirement account within 60 days, you could face a 10% early withdrawal penalty, while also missing out on the tax-free growth that makes a 401(k) so appealing. To avoid any penalties, you'd need to come up with the 20% that was withheld so that you're reinvesting your entire balance within 60 days.
A direct rollover is hands-down the way to go to avoid taxes, penalties, and unnecessary headaches for you.
3. Not comparing the alternatives
Even if your employer allows you to stay in its 401(k) after you leave your job, make sure you consider the alternatives. If you're eligible for a new employer's 401(k), compare the fees and investment options for both plans.
Also be sure to look at whether an IRA is a better option. With an IRA, you can typically invest in whatever stocks, bonds, mutual funds, and exchange-traded funds (ETFs) you choose, plus the fees are way lower. Another advantage is the flexibility, particularly if you're investing in a Roth IRA. For example, you can access your contributions (but not your earnings) any time without taxes or a penalty.
4. Cashing it out
Cashing out your 401(k) can be tempting if you've lost your job or you need extra funds to start a new business. But because of the taxes and early withdrawal penalties, this option almost never makes sense.
Consider the impact of a $50,000 withdrawal made before you're age 59 1/2 if your marginal tax rate is 22% and you live in a state with a 5% income tax. You'd pay:
- $11,000 for federal income taxes
- $5,000 for a 10% early withdrawal penalty
- $2,500 for state income taxes
After taxes and penalties, you'd be left with just $31,500 on a $50,000 withdrawal -- and that's not including the tax-free growth you've missed out on.
5. Forgetting about it altogether
Believe it or not, it's pretty easy to forget about your old 401(k). Fintech company Capitalize estimates that there are 24.3 million forgotten 401(k) accounts holding $1.35 trillion -- yes, trillion -- worth of assets.
If you suspect your old 401(k) is among them, the easiest solution is to contact your old employer, provided that they're still in business. Otherwise, try searching for your former employer using the U.S. Department of Labor's website or search for your name on the National Registry of Unclaimed Retirement Benefits.
Once you locate your old 401(k), make sure you take action. Compare fees and investment options to see if your best option is to keep your money where it's at or roll it over to another employer's plan or an IRA.
