The 401(k) plan is one of the most popular retirement plans available. Employers typically offer these plans for the benefit of their employees. However, many people will change jobs multiple times in their lives, and for some, this can mean having several 401(k) accounts, complicating retirement savings and losing track of assets.
When employees leave their positions, they have three options for their 401(k) plan assets. First, they can cash out their 401(k)s. However, withdrawing funds from a 401(k) plan results in taxes on the money taken out and can also lead to a 10 percent early withdrawal penalty if the employee is under age 59 1/2. Both of these fees eat into savings and can potentially postpone retirement. These losses are entirely preventable with options two and three.
The second option for an old 401(k) plan is to roll it into a new employer’s 401(k) plan. In most cases, new employees are eligible to roll over their old funds into new accounts. However, there are several drawbacks associated with this option as well. Since 401(k)s are employer-sponsored plans, participants (the employees and investors) are tied to the rules and limited by the investment options offered within their new companies’ 401(k) plans. In addition, certain 401(k) plans will have excessively high fees associated with them. Like the penalties of the first option, fees can hurt potential growth.
The final choice available for prior companies’ 401(k) funds is to rollover the assets into an IRA. Either brokerage firms or mutual fund companies will hold the IRA, and the account itself can either be a traditional or Roth IRA. Each of these options has their own benefits and disadvantages.
Brokerage firm-held IRAs, while offering the most flexibility, typically have the highest costs. Although these accounts allow account holders to invest in stocks, bonds, mutual funds and exchange traded funds, certain brokers charge high transaction fees. Conversely, rolling over assets to a mutual fund company is usually the least expensive investment method. However, account holders are limited to the funds offered by their mutual fund companies.
The second consideration for IRAs is to open a traditional or Roth IRA. In a traditional IRA, contributions to the account are pre-tax, and the funds are taxed upon withdrawal. Roth contributions are made on a post-tax basis, and the money in the account grows tax-free and is not taxed upon dispersal. Because traditional contributions are normally made in higher amounts (since they are not taxed), the traditional IRA funds tend to grow more rapidly. However, if the tax bracket that the investor will be in upon retirement is a concern, it may be safer to invest in a Roth IRA that will be untaxed during the investor’s golden years.
There are other tax considerations when rolling over 401(k) assets. Both 401(k) to 401(k) and 401(k) to traditional IRA rollovers will not affect the taxable income of the investor. A 401(k) to Roth IRA will affect taxable income and can potentially increase the investor’s marginal tax rate.
If you roll over your 401(k), there are several steps you must take to ensure a smooth transition:
Check with your current 401(k) provider for eligibility and gather the necessary forms. If your previous employer has not yet notified their 401(k) provider that you have severed ties with them, you may be temporarily ineligible for a rollover. Often, providers will deny claims without any reason given, and this discourages many investors who may not attempt to roll over their funds again. If you are able to roll the funds over, you should ask your former employer for necessary forms in order to begin the process.
Ask what your new provider needs. Your new provider will need a different set of paperwork in order to accept your rollover. Make sure you obtain the required information from your current provider to fill out the new forms properly.
Make sure you select the right options. Occasionally, it can be difficult to fill out all the paperwork required. If you make a mistake, the rollover process can be delayed, costing you time and causing frustration.
Follow up with the providers until you are sure the process is complete. After you submit all the paperwork, you should follow up with both companies until the process is complete. If your funds haven’t been deposited after a few weeks, check with the companies to make sure all the paperwork was received and was correct. If you don’t have time to gather the forms and complete the paperwork, a financial advisor can help you with the process.
A 401(k) rollover offers many advantages for old plan funds. It is important to assess all your options before making any investment decisions, and if necessary, seek the help of a qualified financial professional.
— Rob Hoxton is the president and CEO of HFI Wealth Management, a leading fee-only investment advisory firm. A co-founder of the Rural Financial Planning Project, he began his career in the financial services industry in 1986, and he has won numerous awards for his work in the wealth management area. He can be reached at RHoxton@HFIwealth.com or at 304-876-2619.