Leaving your job is a BIG life change. So, we don’t blame you if your 401k isn’t immediately top-of-mind. Nonetheless, thinking about a 401k rollover is something that we really urge you not to forget.
Don’t Forget Your 401k Rollover Decision
The 401k rollover is a decision that many of us will face at some point or another – anytime you leave a job with a 401k, it’s something you should think about.
Whatever the circumstance, you’re likely to be facing a laundry list of to-dos’, including a 401k rollover. There are the big things like finding your feet in your new job, and also probably deluge of administrative tasks like sorting out your new benefits package, updating your contacts, and the like. It can be an overwhelming time.
But take our advice: don’t forget your 401k rollover decision.
How to Rollover a 401k
Let’s start with your options when it comes to your old 401k:
- Leave your money with your old employer’s 401k plan
- Roll your assets over to an individual retirement account (IRA)
- Roll your old 401k over into your new employer’s 401k plan, if they offer one
- Cash out your full account (take a lump-sum distribution and pay the tax plus a 10% penalty if you’re younger than 59.5)
- Cash out a portion (and pay the appropriate taxes and penalties) and roll over the rest
Note: we generally don’t recommend cashing out your 401k if you are younger than 59 ½ — those 10% penalties and the taxation means it’s rarely a good idea. However, there is an exception to this. See the section below on “When Cashing Out Your 401k Makes Sense”.
A common misconception about 401k plans is that if you leave your funds in the account after leaving the employer, you will continue to receive matching contributions or continue to vest the previously added match. We hate to be the bearers of bad news, but that’s not the case – not only will you not receive any matching contributions, but you won’t be able to contribute to your old 401k at all.
So for most, the decision is clear: rollover your 401k assets into an IRA. In this post, we’ll discuss why that’s the case. (TLDR; it’s because you typically have lower fees, a greater selection of investment options, and potentially increased withdrawal flexibility.)
However, there are specific scenarios (such as owning stock in your company in your 401k) where a cash-out might make sense. There are also some scenarios where high-income earners may encounter a taxable situation when attempting a backdoor Roth conversion after rolling over a 401k into an IRA. If you think this might apply to you, talk to your financial advisor about your rollover options.
The Cost Factor: Rolling Over Your 401k Can Equal Lower Fees
401ks can be costlier than IRAs, mostly if they come with an extra layer (or layers) of fees. First, there are administrative fees. These are in place to cover the “day-to-day operations” of a 401k, including record-keeping, accounting, legal and trustee services. In addition, 401k investment options tend to be more expensive than other investments available outside of a 401k.
All in, 401k fees are, on average, around 1% of plan assets, according to the Center for American Progress.
1% doesn’t sound like a whole lot, but let’s take a look at a simplified example to see how much of an impact 1% can have on your retirement assets.
Say you’re 40 years old with an old 401k from a prior job with $150,000 in assets. That plan charges 1.5% a year in annual expenses. Fast forward 30 years: the account is now worth more than $560,000 (assuming a 6% compounding growth rate and a 1.5% fee).
With a fee that is 1% lower – 0.5%, the value of your portfolio would be a staggering 33% greater in 30 years. If your $150,000 is invested in funds with a 0.50% fee, your net annualized gain is 5.5%. That will turn today’s $150,000 into nearly $750,000 within 30 years. Lowering your investing costs could boost your retirement savings by nearly $200,000 – and you didn’t assume any additional risk for the increased value.
IRA’s don’t come with any of these plan fees, which is a great reason to think about a rollover.
Personal Capital’s free Fee Analyzer will tell you what impact fees might have on your retirement goals.
Investment Options: More Choices When You Rollover Your 401k
The second reason to think about rolling your 401k over into an IRA is to improve your investment selection. Once the money settles into your IRA, you or your advisor can choose among thousands of ETFs, bonds, mutual funds or individual stocks. You’re no longer limited to the dozen or so mutual funds typically offered in a 401k. And here’s a startling fact: by law, 401k plans can offer as few as three investment options.
Mutual funds are not only expensive, but also tend to underperform the market. ETFs, on the other hand, provide a relatively low-cost, tax-efficient way to create a well-diversified portfolio. Low-cost investments help boost your retirement security – without having to ramp up savings or portfolio risk.
Your investment time horizon and risk tolerance, along with several other factors, will ultimately guide your asset class decisions. You can use the Personal Capital Investment Checkup Tool to help determine your target allocation and see how your existing portfolio compares.
Finally, as with any retirement account, when you make trades within your IRA account, you can do so without generating IRS reporting requirements. Think of it this way: when you unload shares, you’re not taking a distribution, and you’re not making a contribution when you use the profits to re-invest. With more flexibility in your investments, this benefit is more pronounced in IRAs.
When Cashing Our Your 401k Makes the Most Sense: Company Stock
In general, we recommend against cashing out your 401k early, since there is generally a hefty penalty for early withdrawals.
However, there is a special case in which cashing out a portion could make sense – and that’s if a portion of your 401k is invested in company stock.
The reason? Company stock has different tax treatment if it’s taken out as a lump sum distribution from a 401k.
Warning: We’re about to discuss something called “Net Unrealized Appreciation” – it’s complicated and only really matters if you have company stock within your plan. The following paragraphs discuss the specifics, so feel free to skip ahead to the next section if this doesn’t apply to you. We won’t blame you!
Typically, whether you withdraw money from a 401k as a lump sum distribution or as income distributions during retirement, you pay tax on all of your withdrawals at ordinary income rates. Gains that came from appreciation of your portfolio and income therefore have the same tax treatment.
Company stock, on the other hand, can be distributed from a 401k as a lump sum and the ordinary income tax rate will be applied only to the cost basis of that company stock. Any growth in your company stock is considered “net unrealized appreciation,” or NUA.
You’ll only pay tax on your NUA once you sell that stock, and if you sell it a year after taking the lump sum distribution, you’ll be taxed at long-term capital gains rates.
There are some other requirements that must be met as part of the NUA rules. First, within one year, you must distribute the entirety of the vested balance held in the plan, including all assets from all of the accounts sponsored by the same employer. All distributions must be taken as shares and cannot be converted to cash at this time. You must have either separated from the company, reached the minimum age for distribution, suffered an injury resulting in disability, or you must have passed away. The NUA strategy must be vetted carefully and is not for everyone, so be sure to consult your financial and tax professionals before moving forward.
Getting Started With a 401k Rollover
Except in the case that you own company stock in your 401k or need access to your funds immediately (and for some reason the 72(t) doesn’t make sense for you), it’s typically best practice to roll your 401k into an IRA. Make sure you talk to your financial advisor before executing a rollover IRA, though, because everyone’s situation is unique and there are always exceptions. For example, if you roll your 401k into an IRA, the Rule of 55 (a provision allowing investors to withdraw retirement funds before the age of 59 ½ in certain circumstances) will no longer apply to you. Once you’ve made the decision to rollover, the process isn’t massively complicated, but there are a few things you should keep in mind.
The first is to make sure you do a “direct rollover.” This means the money is moved directly from your old 401(k) to the new brokerage account or fund family. This is important because if you fail to do a direct rollover, you could be hit with an unwanted tax bill and strict timelines. But don’t let this hinder you: your financial institution of choice should be able to give you step-by-step guidance to complete this process hassle-free.
From there, the world is your oyster! Not only do you have likely lower fees, more investment options, and potential early access to your funds, but you may also continue to contribute. All of these factors make the rollover IRA a great retirement account decision.
Personal Capital offers advisory services in addition to our suite of free tools — schedule an appointment with an advisor to see how they can assist you with your 401k rollover decision.
Disclaimer: The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Third party data is obtained from sources believed to be reliable; however, Personal Capital Corporation (“Personal Capital”) cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Personal Capital of the contents on such third party websites. Certain sections of this blog may contain forward-looking statements that are based on our reasonable expectations, estimates, projections and assumptions. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.