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When you change jobs or retire, what should you do with the money in your 401(k)? You’ve got four choices: You can spend it, you can leave it in your old employer’s 401(k), you can roll it into your new employer’s 401(k), or you can roll it into a self-directed IRA. Today we’re going to take a look at the options.
1. Spend It
Option number one, you can spend it. Let me say this succinctly, don’t do it. The distribution you receive will be taxed as ordinary income. So for example, if you had a $100,000 distribution and were in the 30% tax bracket, you’d net $70,000. In addition, if you’re under 59 ½, the distribution will be subject to a 10% penalty. Need I say more?
The only reason to take your distribution in cash would be, for example, to invest it in your own business or something important like that, having absolutely exhausted your search for another source of funds.
2. Leave It Where It Is
Your second choice is to leave it where it is. If you’ve got a balance over $5000, you can leave it in your old 401(k)—it’s your legal right. And it’s easy. It’s the path of least resistance. You’re already familiar with the plan. You don’t have to do anything but let your employer know you’re going to stay in the plan and, typically, you’ll have one to three months to make your decision. But just because it’s easy doesn’t mean it’s the right decision.
If your plan is a good one, meaning it has many investment choices and low fees, this may be a good option for you. But many 401(k)s (particularly smaller plans) are a rip-off. They charge excessive fees, which means you’ll earn less and which means you may have to work longer and/or contribute more to reach your retirement goals.
And if you leave it where it is, your fees may go up. That’s because many employers subsidize administration costs for their employees and charge full boat for ex-employees. And sometimes the 401(k) rules are different for former employees. You may not have the same access to your plan. Some plans put an annual limit on the number of investment changes former employees can make. So before you decide to stay with your current plan, find out what the policies are for ex-employees.
3. Put It In The New Employer’s 401(k) Plan
Now the third choice is to put it in your new employer’s 401(k)plan. The biggest advantage of rolling your assets into your new employer’s 401(k) plan is simplification.
It’s easier to keep track of your retirement plan assets when they’re all under one roof. You won’t need an additional spreadsheet to figure out your asset allocation. It’s one less password to remember and one less monthly statement in your e-mail inbox.
And maybe your new 401(k) is simply a better plan than the one you left behind. Maybe you’ll have more investment choices and a plethora of low expense-ratio funds. But here’s where it’s important for you to do your homework: Before rolling into your new company’s 401(k), ask for a summary plan description (SPD). This document will tell you everything you need to know. Make sure the plan offers investment choices that meet your needs and have low internal fees.
4. Roll The Money Into A Self-Directed IRA
The fourth and final choice is to roll the money into a self-directed IRA. A self-directed IRA is just what it sounds like. It’s your account; you’re in charge; you get to make all the decisions regarding investment selection; and your money continues to compound on a tax-deferred basis.
It’s oftentimes the best vehicle for your retirement nest egg. You can open up a self-directed IRA with any bank, brokerage, and you can mostly do it online.
The biggest advantage in a self-directed IRA is the sheer number of investment options available. In brokerage accounts, you can invest in stocks, bonds, exchange-traded funds, and a large number of low-cost mutual funds, and often—but not always—there is no annual fee and the cost of buying and selling is minimal. As a matter of fact, most discount and online brokers no longer charge brokerage commissions.
You need to be careful about how you roll your 401(k) into a self-directed IRA. There are two ways to do it—the “indirect rollover” and the “direct rollover”.
The indirect rollover is cumbersome and not recommended. It works like this. Your former employer sends you a check for 80% of the value in your 401(k). 20% will be withheld for income taxes and sent to the government. In order to avoid being taxed on this distribution, you must then write a personal check for 100% of your 401(k) balance—that means you have to come up with your own cash— and then deposit that in your self-directed IRA. And you’ve got 60 days to do it. If you fail to do this within 60 days, you may be subject to a 10% penalty, and the IRS will consider the proceeds from your 401(k) to be taxable as ordinary income. Ouch!
The far better method is the direct rollover. The first step is to open your self-directed IRA then contact your 401(k) plan administrator. Tell them you wish to rollover your 401(k) balance into a self-directed IRA. The administrator will provide you with a transfer form. Simply fill in the form and submit it to your administrator. The transfer typically takes 1 to 3 weeks and 100% of your money is transferred. The best reason to rollover your funds to a self-directed IRA is control. You control the investment selection. You control the expenses. It’s your money. Who better to decide what to do with it.?
Speaking of investment selection, I want to take a minute to talk about the important role of a financial advisor in this picture. Let’s get the cost thing out of the way at the beginning. They say there are 3 ways to become an investor: 1. Do it yourself, learning by trial and error. 2. You can pay tuition and go to school. 3. Pay a fee by hiring an advisor.
The first way, doing it yourself, is by far the most expensive way, in my opinion. I have seen it time and time again. Why? Because there are many tricky aspects to creating wealth through investing that the vast majority of people will get wrong. And getting it wrong here can mean thousands of dollars of loss and the potential loss of a comfortable retirement. A highly risky move.
Some examples of what I’m talking about are trying to control the urge to buy and sell on emotions and failing to have a disciplined process and selling when the markets get scary. These are just a few challenges that can trip you up.
Let’s talk about the second option—going to school to learn. I think you can learn how markets work and what types of behavior can work for you or against you in school. I think you can learn how to trade if you take trading classes, but fundamentally, you will have to find the time and money to achieve this and most of us are too busy with the rest of lives to really concentrate appropriately to increase the probability of success. And you are still coming into the investment world without years of real-world experience. A risky move.
Hiring an advisor isn’t cheap, but it may be cheaper than the two options I just mentioned. If you choose well, a veteran advisor can ensure you stay on track, install a disciplined process and make sure you don’t make the big mistakes. Plus, they can help you with your budget and family money issues, estate issues, and much more. These factors will probably increase your chance of success. All in all, I think the advisor route is the safest and perhaps the least expensive option of the three.
So those are the four options. Consider them carefully. If you want to review them once again, come to our website, stevepomeranz.com, and download it or share it. And while you’re there, sign up for our weekly update to get all of this in your weekly inbox. That’s stevepomeranz.com.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. There are no investment strategies that guarantee a profit or protect against loss. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however, their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.