Since the average worker has more than 10 jobs in their lives, there is a chance you have an old 401(k)at a previous employer.
When I was a financial advisor this was the number one topic I used to help clients figure out.
Most people believe there are only one or two options for their money after they leave a job. However, there are actually a plethora of options.
This is a very confusing topic, so I want to help you understand the options that are available. Hopefully, you will find this quick guide helpful.
1) Do Nothing
Depending on where you worked, as long as there is $2,500 or $5,000 in the account, you usually don’t have to do anything with the money. You can leave the money in the 401(k) plan at your previous employer.
Before you decide to leave the money with your old company, make sure you are offered good investment choices, low fees, and can build a diversified portfolio.
This option is is fine, but there are better ones available.
2) Cash Out Baby
You always have the option to take all of the money out of your old 401(k). This may sound like a great idea if you want to take a vacation, pay off your house, or get rid of credit card debt.
Despite the instant gratification, this is typically the worst option.
Unless you are over the age of 59 1/2, then you will be taxed on all of the money PLUS you will be charged a 10% penalty.
This can get very expensive.
According to the Wells Fargo 401(k) early withdraw calculator, if you took a withdraw of $20,000 from your plan then you would be left with only $13,800 after taxes and penalties (assuming a 15% marginal tax bracket).
The other calculation you should consider is lost growth, dividends, and compounding. If you are only 35, then you could 30 lose years of growth.
Let’s assume you would earn 6% a year on the money. In 30 years that $20,000 would be worth approximately $115,000. So the real cost is $95,000. OUCH!
That’s a nice a chunk of change.
When you are trying to determine what to do with an old 401(k) plan you need to consider taxes, penalties, and lost growth.
3) Rule of 72(t) (What?)
The rule of 72(t) is not well known. I bet a number of financial advisors couldn’t explain how this works.
This is one way for people to take money out of their old 401(k) plans without paying the 10% early withdraw penalty.
The rule of 72(t) states, in order to take penalty-free, early withdraws, the owner must take substantially equal periodic payments (according to IRS methods) for five years or until you turn age 59 1/2; whichever is longer.
This is not usually a good option for younger people.
For example, if you are 40 years old and have $100k in your 401(k) plan, according to BankRate.com, you would only be able to withdraw $3,524 per year.
You would have enough for a small car payment, but definitely not enough to retire.
The older you are, the better this option is for you.
4) Transfer it to Your New Company
If you took a job at another company and they have a 401(k) plan, then you can simply transfer the money to them.
This is a great option because you avoid taxes and penalties. If you are a do-it-yourself type of person, then simply contact the HR department at your new company and they can walk you through the process.
There are a few negatives to consider if you decide on transferring the money to your new company:
- You don’t have total control of investment options
- There may not be enough options to create a truly diversified portfolio
- The plan could be very expensive
5) Rollover to a Traditional IRA
A Traditional IRA works similar to a 401(k) plan. The money grows tax-deferred until you start taking withdraws. When you start taking the distributions, then your money is taxed.
This is one of my favorite options because it is simple, you don’t need to pay any taxes now, and you control your investment options. For most families, this is the best solution.
When I was an advisor, this was the decision 95% of my clients made.
To rollover the money, you first need to open up an IRA. This can be completed by nearly every financial institution in America. Next you would have to fill out paperwork from your previous employer to initiate the rollover.
If you don’t know where or how to open up an IRA, below are a list of great options:
Any of these companies can help you from start to finish rollover the money correctly.
6) Rollover the Money Over to a ROTH IRA (Individual Retirement Account)
The major benefit of a ROTH IRA is all of the money in the account, when you retire, is tax-free! So if you have $500,000 in your account, then you pay no federal income taxes on that money.
Unfortunately, to transfer the money from a 401(k) to a ROTH IRA you would have to pay the taxes on the money now.
This means if you have a $50,000 401(k) and are in the 25% marginal tax bracket, you would have to pay $12,500 in taxes now to enjoy a tax-free retirement.
Typically this is a good option if you are younger, anticipate the same or higher taxes in retirement, and have a long time horizon until retirement.
That same $50,000 could easily grow to $150,000 in the next thirty years. It would be nice to know there would never have to be taxes paid on that again.
If you are considering this option, you first need to open a ROTH IRA. This can be accomplished through any of the companies mentioned above. Next, you would complete the appropriate paperwork from your previous employer.
To see if this is a good option for you, then check out this Roth Conversion Calculator.
Transferring to a ROTH IRA may be confusing and I suggest you talk to a professional to run the numbers to make sure it makes sense.
As you can see there are a number of options for your old 401(k) plan. If you are having trouble determining which option is right for you, then consider talking to a professional.
Do not take any of the information as legal or financial advice. I am not a financial advisor, tax professional, attorney, or dentist.