When you leave a job, you have several options for your old 401(k). You can cash it out, but will have to pay a penalty if you're under 59 1/2. Or you can leave it where it is, consolidate it into your new employer's plan, or roll it over into an IRA. Here's an overview of the options, so you can decide what's best for you.
Option 1: Cash it out
This is usually a terrible idea, but it is one of the options, so it's worth discussing. You can request that your old 401(k) be closed, and have a check for the money in your account mailed to you.
The first problem with this is that you'll have to pay income taxes on the entire amount, unless your 401(k) funds were of the Roth variety. And you'll face a 10% early withdrawal penalty from the IRS unless you're over 59 1/2 years of age (though if you have turned 55 when you leave your old job, you may not have to pay the penalty). In other words, cashing out a $30,000 401(k) would give you just $19,500 after federal income taxes and penalties, and that doesn't even include state or local income taxes you might have to pay.
The second, and worst, problem with cashing out is that you're effectively stealing money from your future self. If you left that $30,000 401(k) invested and earned 7% annualized returns, it would be worth more than $228,000 after 30 years. Would you rather have $19,500 now, or $228,000 in the future? This seems like a no-brainer to me, so resist the temptation to simply cash out your account.
Option 2: Leave it where it is
If your 401(k)'s value is over a certain amount (typically $5,000), you are allowed to keep your money in your former employer's plan. And if you're happy with your 401(k)'s performance, and the investment fees are reasonably low when compared to your new employer's plan or mutual funds you could buy through an IRA, there's absolutely nothing wrong with doing this.
I would suggest at least comparing your fund fees with some alternatives before choosing this option, but it can be a good choice for people who want to leave their retirement savings on autopilot.
It's also worth mentioning that there are some advantages to using a 401(k), as opposed to rolling your money into an IRA, which I'll discuss shortly. For one thing, you can borrow money from your 401(k), but this is not an option with an IRA.
Option 3: Combine it with your new employer's plan
If your new employer offers a 401(k), or other qualified retirement plan, you'll probably be able to move your old 401(k) assets into the new plan (you may have to wait a little while before you have this option). This can be a smart move – after all, it can be convenient to keep all your retirement assets in one place.
My only cautionary advice before choosing this option is to compare your new employer's plan (fees and investment choices) with your old one. Sometimes you'll find that your old plan is substantially cheaper, which is often the case if you move from a large employer to a smaller one. If your old plan has lower-cost investment options, or a better selection, it can be a smarter idea to leave it alone.
Option 4: Roll it into an IRA
The final option is rolling your 401(k) into another retirement account, typically a traditional IRA. This is my personal favorite of the four options, as it gives you increased flexibility to invest your money in what you want, and has some other benefits as well. Advantages to rolling your 401(k) into an IRA include:
- You can continue to contribute to your account if you roll it into an IRA, but you won't be able to contribute any more to your old employer's 401(k).
- You have thousands of investment choices available with an IRA, as opposed to a small selection of investment funds available with most 401(k)s. With a rollover IRA, you can invest in virtually any stock, bond, or mutual fund you'd like. If you want to invest a portion of your retirement savings in say, Amazon.com stock, you can do just that.
- Or, if you choose to stick with mutual funds, you have many more to choose from. You may be able to shop around and find lower-cost funds than the ones available in your 401(k) that accomplish the same objectives.
- Finally, while you can't borrow from an IRA, there are some ways you can use your money early, penalty-free, that are not available in 401(k)s. To name the two most common, you can use up to $10,000 toward a first-time home purchase, and any amount to pay for college expenses.
Which is the best choice for you?
Aside from "cash it out," none of these are necessarily bad options, and the best choice depends on your situation and goals. I tend to be in favor of rolling old retirement accounts into IRAs, but then again, I have the time and desire to research investments and construct my own portfolio. Not everyone does, and that's OK.
Here's the bottom line. If you want the flexibility to invest in virtually any stock, bond, or mutual fund you want, you should seriously consider rolling your 401(k) into an IRA. If you prefer to keep your retirement investing on autopilot (again, nothing wrong with this), the smartest move is to compare your old and new 401(k) plans' fees and investment choices, and pick the more attractive of the two plans.