Sooner or later, you will likely leave your current company for another employer. What should you do with the money that you have invested in your current organization’s 401(k), 403(b), or 457 plans: Leave it in, or roll it over? Do you have a choice?
Chances are you have not been told much by your current company. Even if guidance was provided with your 401(k) plan you while you were employed, you may find information about rollovers strangely lacking. The good news is that moment to make that decision is flexible. You can take action as soon as you leave, or delay it.
In fact, the latter might be best. “it is best to wait, investigate, then decide to transfer,” says Elliot G. Ford, Investment Advisor with Ark Financial in Arlington, WA, who serves organizations nationwide as a broker and retirement plan consultant. “Usually someone in the new company can help you understand the investments, the expenses and the plan terms at the new company.”
Ford suggests comparing the plans’ history of investment returns and expenses. “Expenses are particularly important. Numerous studies have shown that, other than the amount you contribute, the single biggest predictor of the size of your eventual investment nest egg will be the investment’s expense ratios." Expense ratio is the total percentage of assets under management that pays for administrative, management, some advertising and all other operating expenses of a plan. “The effect on a fund’s net return can be significant,” Ford says.
Finding someone in your new company to help you compare your old plan with your new employer’s plan shouldn’t be hard. Most companies have dedicated personnel providing information and are willing to answer questions regarding the 401(k) plan – or there's a handy help line to the plan administrator. They want your money, after all.
Although there's no penalty for keeping your plan with your old employer, you do lose some perks: Money left in the former company’s plan cannot be used as the basis for loans. More importantly, investors may easily lose track of money left in previous plans: “I have counseled employees who have two, three, or even four 401(k) accounts accumulated at jobs going back 20 years or longer,” Ford says. “These folks have little or no idea how well their investments are doing.”
Small accounts left behind are subject to “forced rollouts.” Accounts of less than $5,000 can be rolled out of the plan by the company if a former employee does not respond to a notification letter within 30 days. For amounts under $1,000, federal regulations now allow companies to send you a check, triggering federal taxes, state taxes if applicable, and a 10% early withdrawal penalty if you are under age 59½.
For accounts between $1,000 and $5,000, the company can roll the money into an IRA (in the former employee’s name and Social Security number); these IRAs avoid taxes and penalties but are typically invested in money market accounts with relatively high expense ratios that negate money market gains, often generating zero or even negative returns.
If you decide to roll over an old account, contact the 401(k) administrator at your new company for a new account address, such as “ABC 401(k) Plan FBO (for the benefit of) YOUR NAME,” provide this to your old employer, and the money will be transferred directly from your old plan to the new or sent by check to you (made out to the new account address), which you will give to your new company’s 401(k) administrator. This is called a direct rollover. It’s simple and transfers the entire balance without taxes or penalty.
A somewhat riskier method, Ford says, is the indirect or 60-day rollover in which you request from your old employer that a check be sent to you made out to simply YOUR NAME. This manual method has the drawback of a mandatory tax withholding: The company assumes you are cashing out the account and is required to withhold 20% of the funds for federal taxes, meaning that your $100,000 401(k) nest egg becomes a check for just $80,000 even if your clear intent is to move the money into another plan. Then you have 60 days to invest the remainder (or make up the difference) in your new company’s 401(k) plan to avoid taxes on the entire amount, and possibly a 10% early withdrawal penalty.
Even so, that withheld $20,000 has to be reported on your tax return and could push you into a higher tax bracket. (All 401(k) distributions must be reported on the recipient's tax return, anyway: The old plan administrator should issue you a Form 1099-R.)
For example, you request a full distribution from your 401(k), which has a balance of $55,000. Using a direct rollover, $55,000 transfers from your plan at your old job to the one at your new job. If the payment is made to you in the indirect rollover, $11,000 is withheld for federal taxes and you receive a check for $44,000. For this distribution to be completely tax-deferred, you must deposit the $44,000 from the 401(k) and $11,000 from another source into a qualifying plan within 60 days.
There are a few exceptions where parts of the 401(k) may not be eligible for rollovers. These include:
For those who want to “invest it themselves,” rather than rely on their new company’s 401(k) plan investment offerings, there’s a wide market in which to choose an IRA plan. The same rollover rules mentioned above apply: Rollovers can be direct trustee-to-trustee transfers, or indirect, with the distribution paid to the account-owner; either way, once you start the process, they have to happen within 60 days.
Ford generally favors rolling the money over into the new company’s 401(k) plan, though: “For most investors, the 401(k) plan is the simpler, because the plan is already set up for you; safer because the federal government monitors 401(k) plans carefully; less expensive, because costs are spread over many plan participants; and provide better returns, because plan investments are typically reviewed for their performance by an investment advisor and a company 401(k) investment committee.” (You may also want to look at 5 Essential Retirement Savings Accounts.)
The biggest pitfall is accidentally triggering the withholding tax during a transfer, but if you follow the steps outlined here, that won't happen to you. The next most common problem is abandoning or neglecting an old account. Once again, follow the steps here and you'll be golden.