Old 401(k) or 403(b)? Follow Me!
[Note: For the sake of this post, we will refer to all 401(k), 401(a), 403(a), 403(b), PSP, RSP, TSP, & ESOP’s as just 401(k) ’s. This post is covered by the website disclosure statement]
When working full-time as an investment professional in the world of retirement planning I would often get asked the question “What should I do with my old 401(k) plan?” Many people thought you HAD to rollover your 401(k) account once you left a job, but the answer is you generally don’t have too but is a matter of should you. Now this is never going to be the same answer for each person because it is always dependent upon your unique situation so let’s explore our choices and decide what you should do!
Now when you leave a company you generally will have four choices and they include: One to stay in your 401(k), two move to your new 401k, three move to an IRA, and four to cash out your 401(k). Now for this post we are going to assume you have no need to cash your account out, and yes there are reasons you would do that which I will detail in a future post, but we will be exploring options one through three today.
I have always described choosing which account as being similar to that of choosing the right backpack. For example, you wouldn’t take a day pack for a fifty-mile expedition, just like you wouldn’t take a rigid frame, backcountry pack to the coffee shop.
Now that we have established that you need to choose the proper account for your situation, what are the criteria for determining what matters to you? Well, the best choice EXPLORES all of your options!
[Important Note: Keep a tally list for each of the following sections which columns for each account and rows for each topic. This will make it easier to summarize what options your explored matter most across all accounts. You can make infinite columns depending on the number of 401(k)s and IRA providers you want to compare.]
Expenses: The Fees & Costs
For the first section, you have to ask yourself what fees do the account and investments have? Some 401(k) plans will charge an account fee covering the costs of running the 401(k) plan. However, many IRA providers do not charge a fee to open and maintain an account. On the other hand, some IRA providers do! Shop around and see the basic cost of an account at each of the companies you are considering doing business with, then weigh if this matters to you.
The next question is, how much do the investments offered in your 401(k) cost you? We are talking about the expense ratio. If you are unsure what an expense ratio is, read this brief introduction to them. Nevertheless, in a nutshell, the expense ratio is the cost of a mutual fund to operate. All mutual funds are companies that specialize in either growing or protecting your money. The expense ratio is their cost for doing so and helps keep the lights on and business running!
Now many 401(k) ‘s, but not all, will offer discounted expense ratios on investments because you and everyone in the company are buying in bulk, just like going to a warehouse retailer (think Costco or Sam’s Club). This discount is offered because the investment company is willing to accept less profit per person in return for more people buying it. Generally, from my personal experience, the bigger the company you work for, the less expensive the investments will be!
Now in IRA accounts, you usually have more investment choices. However, you are buying as a regular consumer, meaning you do not have the purchasing power of an entire company’s employee base. As a result, you will generally pay the normal (and potentially higher) expense ratio for investments.
Once you decide how much these expenses matter to you, you can move onto the next leg of our journey, which is protection!
Protections: ERISA & You
Generally speaking, 401(k) accounts offer unlimited protection from creditors due to ERISA, the Employee Retirement Income Security Act. Basically, congress wanted to ensure the safety of 401(k) type accounts, since they can be the only account savers use in their professional lifetime. In addition to being the only savings account employees may use, they are tied to specific companies. Thus, safeguards were implemented so that if a company goes bankrupt, your money does not disappear.
IRA accounts, meanwhile, typically only offer protection in bankruptcy cases. They are not tied to any specific company, they are only tied to you. So, what does protection from creditors mean, and does it matter?
It boils down to two points: Are you likely to be sued, or do you have debt collectors/creditors after you? If either, then you may want to consider staying within a 401(k) plan. This can be with your current or former employer, but you should talk to a lawyer if you have specific questions.
Lastly, some states offer expanded creditor protections for IRA accounts, but I am not a legal guru, and there are fifty states… so if this matters to you, read up on your local laws or get professional advice!
Liquidations: Distributions & Loans
We have now evaluated fees and protections, so we can move on with discussing liquidations. This section boils down to how different retirement accounts allow you to access your money. Some accounts have different withdrawal and loan options than others. If you need the ability to withdraw money in the near future, continue reading this section but skip to the next if there is no likelihood, and you own no company stock in your 401(k).
With 401(k) and IRA accounts, each will have a set of rules on how you can take your money out. This can vary 401(k) to 401(k) and IRA to IRA; I will focus only on generalities as a result.
Some accounts allow you to take liquidations through installments or partial payments; others simply offer one-time payments. Ask your account provider what options they provide and use this to decide what you need. Generally speaking, any withdrawals under age 59.5 from qualified retirements account will be assessed taxes and a 10% early withdrawal penalty (Qualified means tax preferential). The penalty is Uncle Sam’s way of telling you not to touch the money unless you absolutely need it.
What if you don’t want to pay the penalty? Well, here is a shortlist of choices to help inform your decision:
•401(k) accounts generally allow you to take a loan against them, and if you repay it, there are no taxes either. Some 401(k)s only let you take a loan if you actively work for the company; others will let you take one even once you have left
•Retiring the year you turn 55 or older? With 401(k)s, you can withdraw penalty-free when you leave that company the year you turn 55 or older
•Having a child or adopting? 401(k) and IRA accounts can allow withdraws for up to $5,000. This significant life event, and the IRS will not penalize you, but they will tax you!
•First time home buyer? From IRA accounts, you can withdrawal $10,000 without penalty to help facilitate the purchase; you will pay taxes on the money
•Need money for higher education for your dependents or self? With IRAs, you can withdrawal an UNLIMITED amount and only pay taxes
•Do you own company stock in your 401(k)? Then Net Unrealized Appreciation could be something worth considering. NUA is a complex topic to be outlined in a later post. However, its basic concept is the ability to (potentially) arbitrage your tax brackets. This arbitrage means splitting your withdrawal between ordinary income and capital gains tax rates. NUA can result in an overall lower tax rate paid on your retirement dollars. Now the ordinary income piece can be penalized but, the long-term capital gains piece is not
•Do you have large medical expenses? Then you can potentially withdraw from a 401(k) or IRA and only pay taxes.
•Did you receive this 401k from your spouse due to a Qualified Domestic Relations Order? Then any withdrawals you make from this 401k are be penalty-free! These accounts are known as QDROs
[Please note that you have substantial medical expenses, one rollover per lifetime from an IRA to an HSA is allowed, up to that years contribution limit. If you have extremely high medical expenses, this will save you taxes and penalties once withdrawn. Moving your 401k to an IRA and then into an HSA could help save you money! Consult with an account if you decide to do this as the amount is limited.]
Options for Investments
Are you hanging in there? We have now assessed which distribution options matter to you so, tighten the laces on your hiking shoes and let’s continue our trek! Now, you may have been wondering about one of the biggest questions: What about the investment options available to me? You are in luck as we will cover this question now, and it boils down to how you want to manage your money.
If you are a self-directed investor, you may already know what investment choices matter to you. You should ask yourself, does my old 401(k) plan offer me sufficient or unique choices? A simple glance to see if you have any unique investments, such as stable value funds, should always be done. This applies to those that are not self-directed either. If these unique investments matter, definitely take note. Now, if your old 401(k) or new one does not offer unique investments or ones that are sufficient, then an IRA is a viable alternative. IRAs generally offer expanded investment choices, including stocks, bonds, mutual funds, ETFs, options, and other financial instruments, such as annuities.
[Please note that unique investments such as stable value funds pay higher interest rates than money market funds or CDs. They are only offered through 401(k) plans. Other examples include hedge-fund like products that regular investors cannot access without a 401(k).]
If you are not a self-directed investor and want to be hands-off with your savings, this next section is for you. The question that will decide which account is more viable is: Do you want your money professionally managed around your situation for an added fee? Or do you want an automated investment that won’t be tailored to your specific situation but does the work of lowering risk over time automatically?
[If you need help deciding, I will create a future post that outlines the pros and cons of each. My specific preference is automated, but yours may not be.]
If you decide you want a managed solution because of your situation, see which accounts offer them and which one makes you feel the most comfortable. This could include your old 401(k), new 401(k), or IRA account. It could also be just the IRA account. Additionally, each provider may manage your money differently based on the account type, so don’t hesitate to ask for a proposal so you can compare them all. You should make sure to understand any and all costs associated with professional management. There is a reason why managed accounts are shunned by many, and hidden fees are a contributing factor. (Ask the provider to be transparent about the management fee, exchange fees or loads, expense ratios, and any other fees that can be assessed)
Suppose you go with an automated investment, such as a target-date retirement fund. First, look at the different target-date funds offered between your old 401(k), new 401(k), and IRA accounts, and then compare them to see which one you like the best! In this case, weighing the investment cost and its performance track record to other target funds will serve investors best. Personal preference to fund managers or companies can also play into decisions here.
Required minimum distributions, what does that even mean? It sounds strange, doesn’t it?
Well, these are mandated distributions that one has to take. This section only matters if you are approaching the age of 72 or are already taking these withdrawals. Known as RMDs for short, these are withdrawals Uncle Sam makes you take once you attain the age of 72. Essentially, they are sick of waiting for their cut of your tax-differed dollars. Just like how you worked hard to grow this money, Uncle Sam thinks he has worked hard not to touch it!
Jokes aside, RMDs work differently depending on the type of retirement account you have. With 401(k)s, each 401(k) account has to have a withdrawal taken from it, each year. So if you have five 401(k)s, you take five withdraws.
With IRAs, you can combine the total amount needed to be withdrawn from all traditional IRA accounts, then choose to withdrawal that sum from one of them. For example, if you have five IRAs, you can take the total RMD amounts from one of them. This is because with traditional IRAs, the government views them all as the same IRA account, even if they are held at different companies.
Fun fact alert! Combining RMDs applies to 403(b) plans, as the IRS allows all 403(b) RMDs to be aggregated. This is one of the few times 403(b)s are different than 401(k)s.
Now if you are still actively working and your company offers a 401(k) plan, moving your old 401(k) and IRA accounts can be a great option if you are not ready to take these required distributions. This is because the government recognizes that you do not need the income and is kind enough to let you defer it! (If you happen to be a big wig and own more than 5% of the company, this does not apply to you and you will have to take the RMD)
Lastly, with 401(k) accounts, if you have Roth dollars in them, you must take an RMD from the total value, including those dollars. You do not have to take an RMD from Roth accounts with IRAs, only traditional or rollover ones.
Ease: Simplicity of Management
Whoa! We have now reached the second to last category, and it entails simplicity and ease of management. When it comes to keeping track of your savings, the more accounts you have, the more complicated things feel and look. You must track the performance of each and make sure you are using the best investment and withdrawal choices from each account. In other words, it requires more effort on your part.
Suppose you are someone who will not stay on top of two, three, or four accounts. In that case, consolidating into a 401(k) or IRA could make sense, making management easier for you. If you are a very detailed oriented person, this may make no difference. Instead, you may prefer the benefits each account provides and don’t mind using spreadsheets to track them.
Services: Features, & Personal Preferences
We have made it to the final category, and will focus on the services an account provides you. Think of this section as the bells and whistles! Ding ding, whistle whistle. These features will vary greatly depending upon the company and the specific account offered, so this will be a brief summary.
With some companies and providers, 401(k)s can offer financial planning at no added cost. With some IRAs, premium client tiers are offered if you have enough money. The list goes on and on, depending on the provider and the account type you choose. The big thing here is to ask your account provider if they have any special services for that account and assess if these services or features matter to you.
Additionally, this is where personal preferences can come into play. Do you have an opinion that a specific investment firm is better due to how they operate or subjectively make you feel? Does that opinion make you likelier to entrust your money with them?
Everyone under the sun has their own reason as to what company is best. Some reasons include the features certain companies provide, while others are due to specific company mission statements. Boggleheads will tell you there is only one place to invest; others may tell you it the company their parents use. Remember, though, if a particle service, feature, or business model matters to you, evaluate it when deciding between accounts.
Summit Reached: Conclusion
Okay, that was quite the hike, with some treacherous moments. It may have required some additional reading, or it could have been a refresher on things you already knew. Regardless, we summited the mountain of financial knowledge regarding old 401(k)s and what to do with them. So now that you know the different factors in choosing the correct retirement account (i.e., backpack), which will you choose?
It may be tough to weigh which options mattered most during the EXPLORES process, but remember, it is what matters most to you. For some people, these points are trivial since they desire simplicity. For others, the decision could be more complicated. If you fall into the later group, you may want to consider having multiple accounts; this entails leaving money in your old 401(k) and moving the remainder to your new 401(k) or IRA (or any combination of the three).
The account choice process is about you at the end of the day, not Jill or Johnny. If you have a more complicated situation, such as you do back door Roth IRA conversions, your 401(k) is being eliminated, you have multiple RMDs, you need to withdrawal money now, or are concerned about creditors, seek out the appropriate tax, financial, and legal advice from experts. Until our next post, carry on with your journey to financial freedom, and we will chat at the next trailhead.
[Want to learn more about backdoor Roth conversions, check out this article.]
•Does rolling over money from a 401(k) to a new 401(k) or IRA incur taxes or penalties? Simple answer: No. Expanded answer: No, rollovers do not incur taxes unless you default on an outstanding loan from your old 401(k) plan when you do the rollover.
•Can I roll to an IRA and then back into a 401(k)? Simple answer: Generally, you can. Expanded answer: Generally, you can move from a 401(k) to a rollover IRA and then back to a new 401(k) but, always check with the company that administers your new or old plan to see if this is allowed.
•What if I roll over Roth 401(k) dollars? If you roll over Roth 401(k) dollars to another 401(k), they can then move to another 401(k) in the future, generally. Once you roll over Roth 401(k) dollars to a Roth IRA, you cannot roll them back into a 401(k) plan. Once a Roth IRA, always a Roth IRA.
•Can I roll my traditional IRA into a 401(k)?: Sometimes! Check with the company that administers your 401(k) plan to see if they will accept the money as a roll-in from a traditional IRA. Generally, rollover IRAs can always go into a 401(k).
Mile High Finance Guy
finance demystified, one mountain at a time