When you leave a job, you have to decide what to do with your 401(k). Many people just leave their 401(k) with their former employer, but that may not be the best course of action (or rather, inaction). We asked some of our Motley Fool experts whether you should roll over your old 401(k). Read on for their answers.
For the majority of people, rolling your 401(k) over makes sense for a number of reasons.
To start, too few employers offer the best investment options, or have the lowest fee structures, to make it worth leaving your 401(k) for your former employer to manage. Furthermore, the Bureau of Labor Statistics says the average worker will change jobs more than five times between 30 and 46, meaning each job change leaves another 401(k) to try to keep up with. Rolling over your 401(k) can help you achieve the best returns for the lowest cost while also consolidating accounts for your convenience.
That said, if your previous employer has a far superior 401(k) plan, you may want to leave that money where it is. Don't get me wrong -- if the new plan isn't perfect, you should still participate and take advantage of your employer's matching contributions and the tax breaks that 401(k) offers. But you're probably better off following my colleague Dan Dzombak's advice and turning to an online broker for the reasons he describes below.
Yes, you should roll over your old 401(k).
Many 401(k) providers offer limited access to funds while charging high fees. For people with funds in this sort of 401(k), it should be a no-brainer to roll over their account to an IRA. Further, many companies charge quarterly maintenance fees on 401(k)s to people who are no longer employees.
By rolling over your 401(k) to an IRA through an online broker, you'll get greater options and, in most cases, lower fees. There's one caveat, as Dan Caplinger explains below, but in almost all cases you'll get more options, more control over your investments, and lower fees than a 401(k) can offer. If you're looking for an online broker to roll over your account to, check out The Motley Fool's broker center.
Many people say you should always roll over your 401(k), but this generally assumes that your old 401(k) is a bad plan with high fees. Admittedly, it's easy to roll over retirement money into a lower-cost IRA and have complete control over how it's invested, but there are still some situations in which you'd be better off sticking with your old employer's plan.
For instance, if your 401(k) gives you access to a low-cost institutional class of mutual funds, then you might pay less in fees in your 401(k) than you would in an IRA. Most individual investors have to use more expensive retail mutual fund classes, which charge higher annual expenses to their shareholders.
Sticking with your old 401(k) can also be smart if you have employer stock in your account. Under current law, if you hold company stock in a 401(k) account, any gains in that stock can be treated as long-term capital gains, so long as you arrange to have that stock distributed straight to a taxable brokerage account and then sell it. By contrast, liquidating the 401(k) and rolling over the proceeds to an IRA eliminates that favorable treatment.
If you have a typical high-cost 401(k), then rolling over to an IRA makes a lot of sense. But those lucky few with good 401(k) plans should consider sticking with a good thing.
All three of my colleagues make solid arguments for the various options regarding your old 401(k). Regardless of which one you think is best, the most important thing is to keep your money invested. Under no circumstances should you cash out an old 401(k).
For starters, cashing out your 401(k) can cost you quite a bit in taxes and penalties. The money you cash out will be added to your income this year, so you'll have to pay federal and state taxes on it. Additionally, the IRS imposes a 10% early-withdrawal penalty for cashing out retirement funds before you're eligible (usually at 59-1/2 years old, though you can withdraw funds before that age under certain circumstances).
So if you're 35 years old and have $20,000 in your old 401(k), and you're subject to a 25% federal tax rate and another 5% from your state, you'll end up with only $12,000 after taxes and penalties.
However, the real reason to avoid cashing out is the missed investment opportunity. Using the example of a $20,000 401(k) account, if you kept it invested and earned an average of 7% per year (lower than the S&P 500's historical average), it could grow to more than $152,000 by the time you're ready to retire at 65. Would you rather have $12,000 today or $152,000 when you're ready to retire? Seems like a no-brainer to me.