Statistics show that the average person will change jobs 11 times over the course of their life. What happens to their 401(k)?
In this episode, Marc Bautis talks about the five 401(k) options a person has when they leave their job. It turns out that this is one of the most important retirement decisions you will make. Listen in as Marc walks you through the pros and cons of each option, giving expert advice along the way.
In this episode, you will learn:
- How to decide whether to leave a 401(k) where it is or bring it over to your new employer
- The importance of obtaining your fee-disclosure document
- Why there are very few pros to cashing out your 401(k)
- What a “zombie 401(k)” is and how to hunt one down
- And more!
Tune in now to find out what options you can take with your 401(k) when you change jobs.
Marc: We are going to talk about what options you have with your 401k when you leave your job. It may sound pretty pretty straightforward but it’s actually one of the most important retirement decisions that you will wind up making.
Aric: I’m sure there are people out there who have had more than one job and potentially multiple 401k’s This could be a really timely topic for a lot of people that just haven’t done anything yet.
Quote Meme: Average person nowadays changes jobs 11 times
Marc: There is a statistic out there that says the average person nowadays changes jobs at least 11 times during their working career and while they may not have eleven 401k’s, they may have a bunch of them. I’ve also seen people lose track of them. We’ll talk about five different options that you have with your 401k and the pros and cons of each option.
Aric: It’s going to be about how you can help someone make that decision and what they can do with it. Where do we start.
Option 1: Do Nothing
Marc: Option number one which is to do nothing. That’s leaving your 401k where it is. While you’re working at the company generally you have to keep your funds in that in that company’s retirement plan. Once you’re no longer working for whatever reason you have these five options that we’re going to talk about. Option one is to do nothing. Keep it in the existing plan. Generally a company or employer is not going to kick you out of the plan. So that is an option you can keep it in your in your existing plan.
Aric: I can think about a company that I worked for when I was 22 years old. I don’t think we had a 401k. But now I kind of wonder. Maybe when I signed up for everything it was here’s your medical stuff, here’s this stuff. I had to sign these things and go out in the warehouse and start picking up boxes. I don’t really remember. But are there any good reasons to leave 401k with a company that you’re leaving?
Marc: There are actually a couple of reasons why leaving it in the existing plan may make sense.
- Potential to have penalty free distributions prior to age 59 ½. With most retirement plans we are conditioned to think that you have to wait for any withdrawals until you are 59 1/2 otherwise you would have to pay a 10% penalty on top of the taxes due. There are some options where if you keep it in the existing or old 401k you can take money out prior to age 55.
- The other big benefit is creditor protection. So if that is a significant concern for someone that’s another reason why it may make sense to keep it in your old plan. And the reason for this is that the creditor protection is offered under ERISA.
Aric: For the layman out there, what is creditor protection?
Marc: It is protection from creditors. The two most common instances are bankruptcies and lawsuits. Your 401k’s most likely would be shielded from those. But it’s obviously on a case by case basis with it.
Aric: Are there reasons you wouldn’t want to keep it in the old retirement plan?
Marc: There are reasons why you would want to keep it in your old plan. One is there may be more appropriate investments some other place and you have to obviously look at that at a case by case level. But the way the 401K works is usually there’s a menu of 10 to 20 different funds that are available and they for one each 401K is different and they range from having garbage investments to having great investment. So it depends on what investment options exist in your 401K but there may be better investments elsewhere. You may get better service somewhere else and again this is on a case by case basis. If you have questions or maybe you need information on something like taking a distribution having responsive, accurate access to information is important.
There are certain strategies you can’t do in a 401k that you can do in an IRA. One that we’ll talk about is what’s called the stretch IRA. There are some reasons where you’ll be able to get access to your money before 59 and a half in a 401k. And then there’s some reasons or some ways that you can get access to it only in an IRA. So kind of depends on if you need access to it before 59 1/2 and what your reason for needing that access is. There are certain restrictions that are 401K has on when you can take distributions so IRAs tend to be a little more flexible on if you need access to your money. Another big difference is the investment options and the fees associated with your with your 401K. Every 401k plan is different so the fees can be high or they can be low.
Aric: Can you break those down for us as far as what the fees are and how high or low they may be?
Marc: You’ll find that a lot of people don’t think that they are paying any fees. With a 401k plan you’ll often have the following fees associated with it.
- The Administrator
- A recordkeeper – The record keeper keeps track all of the money going in and out of the plan: mainly contributions, distributions and loans.
- The Custodian – This is the financial institution that holds the account. They are providing access to the investments inside your 401K.
They each have a fee associated with their services and in addition there may or may not be an advisor attached to the plan who is also charging a fee. No one does anything for free so they are most likely all charging fees and it’s important to understand what those fees are. We’ll talk a little bit later about how you can uncover what those fees are. The fees can be minimal or they can be they can be pretty harsh.
Aric: It’s a little complicated
Marc: I think that is done on purpose by the financial industry. Fees are definitely important.
Option 2: Transfer it to the new 401k
Option two is similar to Option one of keeping it in the old 401k and is rolling it into your new 401k or your new company retirement plan. If you go back to work to a new company and they offer a retirement plan, most likely you have the ability to roll those old funds into the new plan.
Marc: They are still under the 401K or 403B structure, it’s just under a different company. All these 401k plans are structured differently. So there may be reasons to move it to that new new 401k plan but most of the reasons are generally the same that we just went over with keeping it in the old 401k plan. You have to try and do an apples to apples comparison if these are the two options you’re considering and really look at which plan is better.
Aric: Is that comparison an easy thing to do. If I signed up for a 401k plan when I’m 22 and then eight years later I’m changing to another company. I don’t remember what options I picked. A lot of times some people are more invested in their investments. How do you compare the two plans to know if it’s a better idea to roll it into the new or keep it in the old one.
Marc: there is a way to do the comparison, although it’s not that easy. A recent study by the National Association of Retirement Plan Participants found that 89 percent of 401K participants couldn’t correctly calculate their own account fees and 58 percent didn’t even know there were fees. I definitely can back that claim up because so many people I talk to don’t think they are paying fees for their 401k or on any financial account. Every 401K plan is different in in terms of fees they charge and the investment options that are available. Where I would start is requesting a document called the fee disclosure statement from the plan administrator. Specifically it’s called a 404(a).
401k plans are required by law to list all the fees that the participant has to pay. And it’s not an easy document to go through. So I would be happy to go through it with anyone who would like to put together a summary of the fees they are paying in their 401K plan. That’s the first step of how do I do that comparison. People will look at the investment options in their plan and there are sometimes well-known fund companies that provide low cost investment options. Vanguard is is an example of one. A lot of times people see Vanguard in their 401K plan and think this is great I’m not paying low fees on my investments. However what they don’t realize is that yes Vanguard has really minimal fund fees, but the plan jacks up the fund fee and that’s how they stealthily collect their fees. No one is getting a bill or an invoice for their 401k. They are just taken it by skimming it off the top.
Aric: Oh boy. All right. Are there any other reasons to move to a new plan?
Marc: One of the main reasons is if someone wants to take a loan from their 401k. They have the option of taking either a loan of 50% of their 401k balance or up to $50,000 whatever is less. You can’t do this with an old 401k. The way the loan works is you can take a loan out but it’s paid back via your payroll. A little bit comes out of each paycheck and your loan is usually amortized over 5 years. Money will come out on each paycheck to pay back the loan. You obviously can’t do that with a company where you’re no longer working. So if a loan is important that’s one reason to move it to then to the new 401k.
Option 3: Roll it over into an IRA
Marc: We can move onto option 3 which is rolling it over into an IRA. This is the preferred option with a lot of people. We’ll go over what’s different about the IRA versus what we’ve talked about in option 1 and 2 with the 401k’s. The first thing is you can broaden your investment options in a IRA versus the 401k. In the 401k you are really limited to those 10 to 20 options and they may be good options or they may not be such good options. There’s a lot of different strategies that you can embark on in an IRA with different types of options. Aside from the fact that I come across a lot of people who like to pick stocks in their retirement account. It’s an option in an IRA, not an option in a 401k.
Aric: What are some of the other options within an IRA that the 401K doesn’t have.
Marc: One of them is the ability to use exchange traded funds (ETF’s) in an IRA. You can pretty much come up with any type of investment strategy using ETFs. If you want to invest in some emerging market or if you want to invest in firms that are really focusing on cybersecurity or cloud computing or cannabis you have that option inside an IRA versus in the 401k.
On Episode 22 we talked about ESG investing and how someone can align their portfolio with their with their values. It is a lot easier to do inside an IRA vs. if you were trying to do it within a 401k.
There is also the consolidation of retirement accounts and we touched on this a little bit earlier. An IRA can serve as convenient collection point for all of these plans which leaves you fewer plans to keep track of and watch over.
Aric: How often are people losing track of their old retirement accounts?
Marc: It actually happens more than you think it would. People change where they live ,they change their email addresses, they may change their name when they get married and all of a sudden 10, 20, 30 years go by and they forgot that they had a 401k from a previous employer. We’ve uncovered a bunch of times with different people where they’ve had these retirement accounts that they lost track of. It’s obviously a pleasant surprise when you find money that you didn’t think you had.
Aric: That would be nice. It’s never bad news.
Marc: Another benefit with the IRA is that there are usually fewer restrictions on when you can take distributions. With an IRA you can generally take at distribution in any amount anytime you want. There can obviously be tax or penalty repercussions for doing so but you do have access to that money where it is likely more limited within a 401k.
The IRA can also simplify RMD’s. If you have multiple IRA’s at different places and you calculate your RMD on each of these IRAs separately, but you can actually take the combined amount that you have to take and take it from one IRA. So if you have an IRA that you don’t want to touch because you like the investment strategy in it or you like how it’s performing you can leave that one alone and take your RMD from another IRA.
Aric: That’s nice and gives you a lot of flexibility for for those that are joining the podcast that haven’t heard some of the previous podcasts where we’ve talked about RMD’s. Can you just give a quick overview of what that RMD is?
Marc; RMD is an acronym for required minimum distribution. The way to look at it is you’ve been putting money into this 401K or IRA over the years and getting a tax deduction every year that you put money into it. At some point Uncle Sam and the IRS say it’s time to pay up. So they allow you to keep taking that deduction up until age 70 1/2and then they force you to start taking money out. And when you start taking money out it shows up as ordinary income that you have to pay tax on. So there’s a calculation that’s done every year to calculate the amount that that someone has to (required) take out.
Aric: Thank you for explaining that I didn’t mean to derail you. Is there anything else.
Marc: We need to go over just one other one other thing. There are a number of estate planning benefits that an IRA offers at the 401k doesn’t.
- You can split up your IRA and leave it to different beneficiaries.
- You can also if you’re if you want to have your beneficiary be a trust. It’s a lot easier to do in an IRA of most 401k’s will restrict it.
- There’s also the Stretch Ira that I mentioned earlier which is where a non-spouse beneficiary can take the minimum distribution calculated over their IRA life expectancy. This allows the IRA to grow longer tax deferred versus in a 401K where you generally have to deplete or distribute it in a five year period. It allows you to keep it under a tax sheltered umbrella for a little bit longer.
To summarize: There is a lot more control you have in an IRA versus a 401K.
Option 4: Cashing out your 401k
Option four is generally referred to as cashing out or the nuclear option.
It’s generally not a good idea because this is when you instruct the financial institution administering the 401k to send you a personal check for the amount that’s that’s in your in your plan. It’s great that you get this big chunk of money, but now you have to pay ordinary income tax on it. And if you are younger than 59 1/2 you’re most likely going to have to pay a 10 percent penalty on top of it. And to throw salt on the wound you no longer have this money saved for retirement. You may have planned on working until age 65 but not that you just took all your retirement funds out the projection may look like 70, 75, or 80. The 10% penalty is basically the government trying to promote saving for retirement and trying to dissuade you from taking that money out.
Aric: I understand that viewpoint. They may be trying to help people, but I can think of one situation where somebody would want to cash that out is if they lose their job and they need to pay expenses and they don’t have a good emergency fund. RYou’ve talked about that on previous podcasts as well as far as being safe and planning correctly with your finances. But some people might not have an emergency fund or six months worth of salary saved up just in case and they may need to do something about that. Are you seeing a lot of people take that option?
Marc: Unfortunately it does happen a lot. Like you said there’s a negative tax impact and everyone knows you shouldn’t you shouldn’t do it. But people have to put food on the table and have to pay living expenses. I think a lot of cases you mentioned with proper planning it could prevent a lot of it. Yeah.
There is one strategy where it may make sense to take that lump sum distribution and that’s if you’re implementing a net unrealized appreciation strategy (NUA). This is another topic we talked about in our last podcast (Episode 24). This strategy relates to company stock in your retirement plan and how you may be able to save on taxes by paying capital gains tax now versus ordinary income tax so if someone is interested in that you can go to agentofwealth/24 and listen to that episode or you can give me a call and I’d be happy to talk about that.
Option 5: Convert your 401k into a Roth IRA
The last option is to convert your 401k to a Roth IRA. This is another topic that we’ve actually talked about a lot on previous podcasts. The way it works is that funds go from your pre-tax plan into a Roth IRA. It is a taxable event which means the amount that you convert will be added to your tax return as income for the year. But the benefit of a Roth IRA is that distributions from it when you retire come out tax and penalty free as long as you’re over 59 1/2 and have had that Roth for more than five years.
Aric: A question on everybody’s mind is what if taxes go down in the future. For me now I’ve paid way too much upfront and now I’ve lost money.
Marc: If tax rates do go down or if someone’s overall income goes down in the future it may have worked out better if they kept the money in the traditional IRA or a traditional 401K. It’s not right for everyone but you should probably do that analysis. You can save a lot in an account growing tax free over time. There are also estate planning benefits to the Roth IRA.
Marc: It takes the unknown out of what the tax rates will be in retirement and from what I’ve seen one thing retirees don’t like is uncertainty. And especially when the uncertainty is around money. There will always be uncertainty whether it’s tax rates, market volatility, inflation, or health care. The more uncertainty that we can remove I think it gives people that that peace of mind and, and you know really helps set them at ease with it.
Aric: Marc, I could agree more about unknowns. They’re terrible. Nobody wants the unknown of what’s going to happen. Iis there anything else we need to add to this before we close the show?
Marc: I think that the last thing I want to add is that you don’t have to do this analysis alone. It’s definitely not an easy decision. We went over five options. There are pros and cons to each option. Everyone’s situation is different so what makes sense for one person may not make sense for someone else. I help people unpack this decision to go through the analysis and everyone that I go through it with the reaction is the same. They are relieved to have help going through the options and looking at the pros and cons as it relates specifically to them. I’m happy to help anyone go through analysing what is the best option for you.
Aric: Marc, as we’ve been talking I kind of feel this tightness in my chest because now I really don’t remember if I had a 401k at that company that warehouse that I worked at when I was 22. Do you have ways for people to find old for one case or you know help hunt them down?
Marc: Surprisingly this just happened a couple of weeks ago where we helped someone track down a zombie 401k. We’ll look at each employer that they worked at and what happened to that employer over time. The company may have merged, they may have been acquired and then that company may have been bought out or merged with another company. We can track down who the current employer is, find who is administrating that 401k plan and then track it down with the person that way. These are called Zombie 401k’s and there’s a lot of them out there, and they are un-managed. They may just be sitting in cash for the past 20 years and it probably makes sense for someone to do something with them.