By Joe Udo
When you retire, you need to figure out what to do with the 401(k) from your former job. There are a few options to consider, and it is very important to understand all the options. If you are under 59 1/2, it is essential to decide which option is best for your financial situation.
Here are the options and the pros and cons of each.
Leave the 401(k) With Your Employer
Ease. This is the easiest thing you can do. You are familiar with the plan and the investment options. If you are satisfied with it, then leaving it with your employer could be a good option.
Tax. The account remains tax-deferred and will grow without being taxed.
Rebalancing. Most 401(k) accounts do not charge a fee to transfer money between investments. This makes it painless to rebalance once a year.
Asset allocation. When most people retire, they want to invest a bit more conservatively, and it’s a good time to change their asset allocation. It’s usually easy to do this in the 401(k) plan without incurring a transaction fee.
Loan. You may be able to borrow from the 401(k). This can be useful if you are under 59 1/2 and need some money before then. Check with your employer to see if this is an option because the plan could have some restrictions. Keep in mind that if you can’t pay back the loan, you will have to pay the 10 percent early withdrawal penalty.
Multiple accounts. If you have many employers on your way to retirement, you may have more than one 401(k) account. Managing multiple accounts can be a lot of work.
Employer stocks. Some employers invest the 401(k) in their stock. Once you leave your employer, you may not want to be invested in that company anymore.
Limited choices. Most 401(k) plans have limited investment choices.
Future changes. Your employer can change the 401(k) plan at any time. If you do not check your 401(k) plan often, you may not know what kind of changes are coming to your account. A fund that you are invested in may no longer be available and the money is usually swept into a default fund.
Roll Over to an IRA
Control. You will have more control over your investments. If you roll over to a discount brokerage, there are many more investment choices than in any 401(k) plan. Rolling over to an investment management company like Vanguard or Fidelity will also give you more choices.
Low fee. If you roll over to Vanguard or Fidelity, you will be able invest in low-fee mutual funds and ETFs. Many funds in most 401(k) plans have high fees and cannot beat the equivalent Vanguard funds.
Consolidation. If you have many 401(k) accounts, it is a good idea to consolidate them into one account. This will be easier to manage. The investment firm can also help you with asset allocation because they will have a better picture of your portfolio.
Penalty-free withdrawal for some circumstances. Usually, you have to pay a 10 percent early withdrawal penalty if you are under 59 1/2. However, there are some expenses which you can withdraw without paying penalty such as disability, higher education, first home, medical insurance, and more.
Financial adviser. The investment firm may offer the service of a financial adviser. The adviser could be helpful if you need assistance with your retirement investment.
Trading cost. You may have to pay commissions when you trade your investments. This makes rebalancing a bit more painful than in a 401(k).
Financial adviser. The financial adviser from the investment firm may not be the right fit for you. Some advisers will try to sell you a product that they make commission on. You don’t have to take their advice, though.
More responsibilities. You have a lot more responsibilities over your retirement portfolio when it is in an IRA account. You could invest all your money on the Facebook IPO, and that’s your choice.
Cash is king. You’ll have a lump sum to do whatever you want with.
Penalty. If you are under 59 1/2, then you will have to pay the 10 percent early withdrawal penalty in addition to the income tax.
Income tax. If you have a large 401(k) account, you will pay more tax on one big withdrawal. It’s better to withdraw just enough for your expenses and pay less tax.
No more tax-deferred benefit. If you left the money in a tax-deferred account, it can grow tax-free. You also do not have to pay tax on the dividend.
Personally, I would roll over my 401(k) to an IRA account at some point. I think it’s OK to leave the 401(k) at your old employer for a while if you have a good plan, but in the long term, it’s better to have full control of your retirement portfolio. Cashing out is not a good option unless you really need the lump sum. You’ll pay more tax and lose the future earning of the portfolio, which doesn’t make sense if you want to fund your retirement years.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.
Earlier on Huff/Post50:
1. Start Saving
Americans spend an average of 20 years in retirement. If you're not saving, it's time to start. Begin small if you have to, and try to increase the amount you save each month. The sooner you start putting funds aside, the more time your money has to grow.
2. Estimate Your Retirement Needs
Experts estimate that you will need about 70 percent of your preretirement income -- for lower earners, the figure is 90 percent or more -- to maintain your current standard of living when you stop working. Use <a href="http://www.choosetosave.org/ballpark/" target="_hplink">this calculator</a> to come up with a ballpark estimate. Research shows that people who try to estimate their needs in advance ultimately save more for retirement.
3. Contribute To Your Workplace Plan
If your employer offers a retirement savings plan, such as a 401(k) plan, sign up and contribute as much as you can. Your company may kick in a match, and deductions can be automatically taken from your paycheck. Over time, compound interest and tax deferrals can make a big difference in the amount you accumulate. Make sure your plan isn't a lemon by searching the website <a href="http://www.brightscope.com/" target="_hplink">Brightscope.com</a>. If it falls short, ask the management to do something about it.
4. Learn To Invest
How you save can be as important as how much you save. Inflation and the type of investments you make play important roles in how much you'll have saved at retirement. Know how your savings or pension plan is invested. Learn about your plan's investment options and ask questions. Put your savings in different types of investments. By diversifying this way, you are more likely to reduce risk and improve return. Your investment mix may change over time depending on a number of factors such as your age, goals, and financial circumstances. Financial security and knowledge go hand in hand.
6. Don't Touch!
If you withdraw your retirement savings now, you'll lose principal and interest; you might lose tax benefits or have to pay withdrawal penalties. If you change jobs, leave your savings invested in that employer's retirement plan. Or roll them over to an IRA or your new employer's plan.
5. Understand Fees
The cost of your investments makes a big difference. Index funds are a good option for reducing costs. The Labor Department provides this example: Assume that you are an employee with 35 years until retirement and with a 401(k) account balance of $25,000. If the returns on investment for your account for the next 35 years average 7 percent and the fees and expenses reduce this by 0.5 percent, your account balance will grow to $227,000 at retirement, even with no further contributions. If the fees and expenses are 1.5 percent, however, your account balance will rise to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.
7. Open An Individual Retirement Account
You can put as much as $5,000 a year into an individual retirement account (or IRA). Those 50 or older can contribute even more. You can also start with much less. IRAs also provide tax advantages. When you open an IRA, you have two options: a traditional IRA or a Roth IRA. The tax treatment of your contributions and withdrawals will depend on the option chosen. You can set it up so that an amount is automatically deducted from your checking or savings account and deposited in the IRA.
8. Find Out About Your Social Security Benefits
Social Security pays benefits that are on average equal to about 40 percent of what you earned before retirement. You should receive a statement each year that gives you an estimate of how much your benefit will be and when you can receive it. For more information, visit the<a href="http://www.ssa.gov/" target="_hplink"> Social Security Administration's website</a> or call (800)772-1213.