How many jobs have you had since you turned 18? If you’re like most Americans, you have had at least a handful. In fact, the average is around 11. At each of these jobs, you may have had the opportunity to contribute to a 401(k). While it’s great to move to a better job with more opportunities, you don’t want to leave behind the thousands of dollars that may have accumulated in your 401(k).
You may have left your 401(k) at your previous employers, or you may have chosen to roll it over when you left. When people leave a 401(k) with their previous employers, they are more likely to forget about the account. They cannot continue to contribute to it, they cannot make any investment choices, and the investment fees continue to accumulate.
You may not have a choice; your former employer may force you to move your 401(k) when you leave your employment with them.
What is a 401(k)?
A 401(k) is a defined contribution plan. Employees can make contributions on a pre-tax basis. In many cases, the employee is able to make investment choices. In some plans, the employer contributes as well. They may match an employee’s contributions up to a certain percentage. Whenever possible take advantage of this match. If your employer is willing to match 4%, deposit at least 4% into your 401(k).
What is a 401(k) Rollover?
Rolling over a 401(k) is the process of taking the money invested in a 401(k) with a previous employer and moving it into a new account. You don’t have to pay any taxes on the money you are rolling over, as long as you do it directly.
You can transfer money from a previous 401(k) into an IRA or a 401(k). You can even do a reverse rollover — move money from an IRA into a 401(k). In many cases, this is not the best choice.
Direct vs. Indirect Rollover
Direct Rollover: In a direct rollover, the money from a previous 401(k) is directly transferred into another retirement account, such as an IRA. If you, the account owner, never touch the money, you won’t have to pay any taxes or penalties on the money.
Indirect Rollover: With an indirect rollover, there is an additional step that introduces a lot of risk. Instead of transferring the money directly from one retirement account to another, the cash goes to you first as a check. You have 60 days to deposit the money in a new retirement account. You face withholding taxes and penalties for early withdrawal if you don’t deposit the money in a new retirement account before the deadline. Indirect rollovers can be made once a year.
Withdrawing your money before reaching the age of 59 and a ½ usually results in a 10% withdrawal penalty. There are exceptions. This penalty is to encourage investors to stay in employer-sponsored retirement plans.
Another consideration is that your previous employer is required to withhold 20% for federal income tax purposes if you do an indirect rollover. If you do not roll over 100% of the 401(k), it will be considered a distribution, and you will be taxed on it. To avoid being taxed and penalized on this 20%, you must cover the 20% and include this amount in your rollover contribution.
The three options for an old 401(k)
You could leave your money in your old 401(k). This is a potentially good choice if you feel the investments the plan is making are solid and the fees are low. However, there is usually a minimum balance requirement, typically $5,000. In most cases, the fees are not low, and you are better off doing a direct rollover into an IRA.
You could roll over the 401(k) into your new employer’s plan. This seems like a great option because you will have all your investments in the same place. Another bonus is that you have higher contribution limits with a 401(k) than with an IRA. However, there are usually a lot of restrictions when rolling money over from a previous employer’s plan to a new employer’s plan. Some employers may not allow it.
You could roll your money into an IRA. IRAs give you a lot of control over your money. Instead of a handful of investment options, there are likely to be thousands.
You could cash out your 401(k). This option is subject to taxes and a 10% penalty if you are not 59 and a ½. This distribution will be added to your other taxable income and could raise you to a higher tax bracket. Cashing out your 401(k) is not the best option unless you desperately need the money.
There are many options for investing your retirement funds. The best choice for you depends on many variables, such as your current income, whether your employer is matching the funds, your current cash flow situation, and your age.
There is no one-size-fits-all guide to investment. Working with a wealth manager can ensure you make the best financial decisions for yourself and your loved ones.
