If you leave your job and have money in that employer's 401(k) plan, it can be confusing to decide what to do with your account. There are several options that may be available to you, and while one of them is almost always a terrible idea, there's a solid case to be made for the rest. Here's an overview of what you might be able to do with your ex-employer's 401(k) plan, and how to decide the best move for you.
You have several options with your old 401(k)
There are four basic choices you have with a 401(k) after you leave a job:
- Leave the account alone, in your old employer's plan.
- Roll your 401(k) into your new employer's retirement plan.
- Roll your 401(k) into an IRA.
- Cash out the account.
It's worth mentioning that not all of these might be available to you – specifically the first two. Many employers only allow you to leave your account in their plan if you have more than a certain amount of assets. And some employers require a certain waiting period before you can roll an old 401(k) into their plan. You'll need to check with your plan administrators to determine your options.
Having said that, the only option on the list that is a bad idea is cashing out. In an immediate sense, you'll need to pay income tax and an early withdrawal penalty (unless you qualify for an exemption). Not only that, but you'll effectively be robbing your future self, as a seemingly small 401(k) balance could grow into a surprisingly large amount by the time you retire, especially if you're young now.
The best choice among the other three options varies from person to person. Here's a closer look at why you might want to keep your 401(k) assets in an employer's plan, as well as why you might want to roll your account into an IRA.
If you like investing on auto-pilot, an employer's plan could be the best choice
Many people don't have the time, desire, or knowledge to actively invest their retirement funds, and to be clear, there is absolutely nothing wrong with that. In fact, Warren Buffett has said several times that passively investing in low-cost index funds is the best option for the majority of Americans.
Depending on your former employer's policy and your account's value, you may have the option of leaving your account where it is. You won't be able to add to your account, but your funds will stay invested and continue to grow.
Likewise, depending on your new employer's policies, you may be able to roll your old 401(k) into your new plan. The obvious advantage of doing this is that all of your retirement funds will be in one place, which makes it easier to track your savings progress and make sure your investments are properly allocated.
The other major consideration is fees. Despite a common misconception, investing in a 401(k) is not free. At the very least, the individual investment funds offered by your 401(k) charge management and administrative fees, which are collectively referred to as an expense ratio. Compare the fees that you're paying in your old plan with those charged by the investment options of your new plan. If your old plan is significantly cheaper than your old plan, it may be smart to leave your 401(k) where it is. Or, if both plans are relatively expensive, it may be a better idea to roll it into an IRA, as I'll discuss in the next section.
Why you might want to roll your 401(k) into an IRA
In my mind, the number one reason to roll over a 401(k) into an IRA is the wide variety of investment options available to you. As you probably know, with a 401(k), you generally have the choice of a few dozen investment funds, at most.
On the other hand, in a rollover IRA, you can invest in virtually any stock bond, ETF, or mutual fund that you want. If you want to invest some of your retirement savings in stocks like Apple, ExxonMobil, and Berkshire Hathaway, an IRA will allow you to do it.
You can also invest passively through an IRA, and because of the vast selection of investment options, you may even be able to find ETFs and mutual funds that accomplish the same objectives as those in your 401(k), but with lower fees. For example, in a rollover IRA, you can choose ETFs like the Vanguard S&P 500 ETF, which has a rock-bottom 0.04% expense ratio. Can your 401(k) funds beat that?
Many brokerages that offer rollover IRAs also offer ready-made portfolios and free retirement planning tools you can use.
Regardless of the options, the general downside to a rollover IRA is that it usually requires more work on your part than investing in a 401(k). Even so, if all of your 401(k) options have relatively high fees, it can be well worth the small time commitment that's needed to roll your account into an IRA and select appropriate investments.
The Foolish bottom line
To sum it up, there are four basic options that you may have when it comes to an old 401(k), and aside from cashing your account out, none are necessarily bad choices. However, all three other choices have pros and cons, and one of them could make more sense for you, so be sure to thoroughly evaluate all of your options.