When rolling over your 401(k) is the wrong move
The average U.S. worker switches jobs 11 times before retiring, according to the Financial Industry Regulatory Authority.
So chances are good you'll be confronted with this question more than once: What should I do with my 401(k) when I leave my job?
In most cases, it's a good idea to roll the funds over into an IRA or move them to your new employer’s 401(k) when allowed, particularly if you'll have access to a broader selection of investments by moving your money. (Whatever you do, don't cash out your retirement savings when you switch jobs.)
And as you hop from job to job, keeping all or most of your retirement savings in one account makes it easier to allocate assets correctly to attain the right risk-return profile.
But this argument doesn’t always apply.
Here are 9 situations when it makes more sense to leave your old 401(k) alone.
The average 401(k) plan has just eight to 12 investment options, which restricts your freedom to choose the funds that best suit your investment goals.
If the few funds available were some of the best choices, this limitation wouldn’t matter so much.
But the funds in a 401(k) often suffer from active management, meaning a fund manager pursues a certain investment strategy, usually in hopes of beating the market but generally failing in the process.
Passively managed funds try to earn the same returns as the market and tend to succeed.
Before you decide to move your 401(k) assets from your old employer to your new one, compare the investment options available in each plan.
If your old employer’s plan has better fund choices than your new one, leave it alone.
If neither plan is great, a rollover is probably your best choice.
You want a plan that offers passively managed funds with broad exposure to domestic stocks and bonds and probably some international stocks.
Fees are one of the biggest predictors of how much you’ll earn from your investments.
If your investment choices are limited, the investment company basically has a monopoly when setting its prices, called expense ratios.
In choosing your investments, you’d be wise to pick funds with extremely low expense ratios, like a Vanguard target date fund with a 0.18% expense ratio.
Your 401(k) plan might limit you to funds whose expense ratios are closer to the industry average: a significantly higher 0.99%, according to the Investment Company Institute.
If you have $50,000 in your 401(k), the difference between a 0.18% expense ratio and a 0.99% expense ratio is $405 a year.
Sometimes, however, investing through a 401(k) means your fees are extremely low. Because your employer is funneling so many people to particular investments, those investments charge rock-bottom fees.
If you’re paying low fees through your former employer’s 401(k), that’s a compelling argument for staying invested in that plan. Beware, though, 401(k) plans sometimes charge higher fees to former employees.
Can anyone really outperform the market in the long run? It’s a controversial topic with no clear answer.
Famed investors like Warren Buffett and Peter Lynch seem to indicate that beating the market in the long run is a real possibility.
When investors do defy the odds, even the experts can’t say for certain whether it was skill or luck that made them so successful, and there are rigorous studies that give the upper hand to luck.
Still, if the 401(k) portfolio you hold through your former employer has a long-term track record of beating the market, why would you mess with a good thing?
Short-term outperformance, on the other hand, is more likely to be a fluke, a statistical outlier. It doesn’t give you enough information to base your decision to leave your old 401(k) in place on investment performance alone.
Keep in mind that a well-performing portfolio is most likely to continue its stellar performance if it has rock-bottom fees and is passively managed.
Some 401(k) plans offer exclusive access to independent financial advisers.
A 401(k) financial adviser can help you select the best investments for your timeframe, goals and risk tolerance; determine what percentage of your paycheck you should defer into your plan to meet your retirement savings goals; and help prevent you from making emotional decisions like letting a lack of knowledge scare you away from dealing with your 401(k) at all or making poorly timed trades based on market sentiment.
Most investors underperform the market on their own; a financial adviser can help you keep pace with it.
Have you developed a relationship with someone you trust, whose advice has helped you and whose fees are low (1% or less of assets under management per year)? If so, you might want to keep your old 401(k) so that adviser can continue helping you manage your assets.
If you open a new 401(k) with your new employer, make sure to tell your old financial adviser so they can adjust your asset allocation if necessary.
Did you turn 55 at any point in the year when you stopped working for your former employer? Are you younger than 59 1/2, the usual age at which you can start taking 401(k) distributions?
If so, you might not want to roll over your 401(k) into an IRA.
If you leave your job, you can take withdrawals penalty-free at a younger age from a 401(k) than from an IRA.
If you’re unemployed, your 401(k) might be a good source of income until you can find work again.
It’s a better option than going into debt.
Tread carefully, though: The downside of taking distributions at a younger age is that you have a smaller account balance earning investment returns for you. The power of compound returns diminishes as your nest egg shrinks.
Before you start taking distributions at an early age, think about the long-term implications of trading off money now for money later.
Rolling your 401(k) over into a traditional IRA instead of a Roth avoids paying your marginal tax rate on the converted amount.
Assuming that your marginal tax rate is higher in your working years, it’s better to incur the tax bill in retirement. Then, your income should be lower, bringing your marginal tax rate down and saving you a significant chunk of change.
If you’re 70 1/2 or older, this tax-avoidance strategy could be less effective than you hoped.
Traditional IRAs require you to start making withdrawals called required minimum distributions by April 1 of the year after you reach age 70 1/2, even if you’re still working.
That means you’ll pay your marginal tax rate on those distributions, just like you would have paid your marginal tax rate on the balance of your 401(k) if you rolled it into a Roth.
If you keep the funds in your former employer’s 401(k), you may not have to start taking minimum distributions at age 70 1/2 as long as you’re still working and the plan’s rules allow it.
Rolling over your money might expose you to bad actors.
Bloomberg recently reported that investment brokers have been cold-calling workers of large companies like AT&T, Hewlett-Packard and UPS to convince them to roll over 401(k) balances into IRAs.
The brokers earn big commissions when they convince their new clients to purchase particular investments within their IRAs.
Unlike a financial adviser, who has a legal duty to act in the client’s best interest, brokers are required only to recommend "suitable" investments for their clients, a requirement that leaves plenty of room for conflicts of interest.
Bloomberg found that some of these workers had lost hundreds of thousands of dollars in the risky investments brokers sold them, and dozens of clients have filed complaints with regulators.
Ignore sales pitches to roll over your 401(k). If you want to move your money, initiate the transaction yourself through a reputable major brokerage. Then, choose your own plain vanilla, commission-free, low-fee investments, like an S&P 500 exchange-traded fund and a total bond market ETF.
Doing a 401(k) rollover into an IRA or moving 401(k) funds from one employer to another requires carefully following IRS rules.
It would be a shame if you made a mistake that caused the IRS to consider your transaction as "cashing out," requiring you to pay a 10% early withdrawal penalty.
A common pitfall is botching an indirect rollover. If the old 401(k) funds go into your checking account instead of directly into your new rollover account, you’re more likely to accidentally break the rules.
A major brokerage like Vanguard, Schwab or Fidelity can walk you through the process so you don’t make any mistakes.
They can help you open your new account, fill out the forms for you and move the funds directly from your old account to your new one (called a "trustee to trustee" transfer), ensuring you don’t throw away money on penalties.
Just don’t rely on them for financial advice unless you’ve specifically hired one of their financial advisers, and ignore any sales pitches for investment services or products you probably don’t need.
It doesn’t matter if you’re earning better returns if you forget your account exists. Only people who are really on top of their finances should leave a 401(k) with an old employer.
Here’s how to make sure you don’t lose tabs on your old plan:
- If you change your address, phone number or email address, notify your old plan.
- If you learn that your former employer has moved, been acquired, merged with another company or gone bankrupt, contact the plan administrator or the company’s human resources department to see how the change will affect your 401(k).
Even if you forget about your account, your money is protected under federal law.
You can find records of past contributions on old W2s, and you can track down old accounts using the National Registry of Unclaimed Retirement Benefits or the U.S. Department of Labor’s Abandoned Plan Search.
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