10 Reasons Why You Shouldn’t Leave Your 401(k) with Your Ex-Employer

What Are the Choices for Managing Your Prior Employer’s 401(k)?

Make the right choice, and you can grow what has accumulated in that tax-advantaged account into a healthy nest egg. Make the wrong choice, and it could affect how much money is available for you to enjoy during retirement.

• Do nothing and leave your investments in your ex-employer’s 401(k), 403(b) or similar account.
• Cash out your 401(k) and settle with the IRS on the taxes and penalties due.
• Roll your 401(k) over to your new employer’s 401(k).
• Roll your 401(k) assets into an IRA without triggering a taxable event.

Do nothing

Doing nothing with your ex-employer’s 401(k) represents the path of least resistance, which far too many people choose.

One study “estimated that there are over 24 million forgotten 401(k) accounts holding 1.35 trillion in assets.”¹

While employer-sponsored plans can offer some unique advantages–such as penalty-free distribution for retirees between ages 55 and 59½ and freedom from required minimum distributions (RMDs), if you are still working for the employer beyond age 72–the downsides are many. These downsides can include limited investment choices (many of poor quality), high administrative fees, and complicated RMD rules.

Note: An RMD is the minimum amount you must withdraw every year, after you turn 72, from your qualified tax-deferred retirement accounts.

Cash out

As for cashing out your 401(k), there is little reason to recommend this unless you are facing a dire need for cash. You will have to pay taxes at your present tax rate, plus any penalties.

Rolling your 401(k) over to your new company’s retirement plan

The wisdom of rolling your 401(k) over to your new company’s retirement plan depends on the new plan’s investment options, fees, and other terms and conditions.

Rolling your 401(k) over into an IRA

Rolling your 401(k) over into an IRA–whether traditional or Roth–offers a series of benefits (listed below) that you might want to consider as you make your final decision.

Ten Benefits of Rolling Your Old 401(k) into an IRA

The more obvious benefits include:

1. Greater control and access: With an IRA, you have control of the plan, which you can choose to have managed by your financial advisor. With a 401(k), your ex-employer is in control.
2. More investment choices: Your investment options within IRAs are virtually limitless and no longer restricted to the investment menu selected for the sponsoring employer’s plan. Options range from stock and bonds to ETFs, REITs, and other security types, allowing you to tailor your selection to your specific performance target and risk tolerance.
3. Better investment choices: Your investment choices with IRAs run the whole gamut regarding investment quality. With 401(k)s, your options are typically selected by the plan’s trustee, who has no particular motivation to maximize the return on your investments. The result can be restricted diversification, increased risk, and hampered returns.
4. Lower fees: The fees associated with retirement accounts have become more transparent in recent years, making it easy to identify potential costs through each plan’s participant fee disclosure. IRAs do not incur many of the costs found in 401(k)s, ranging from recordkeeping and custodial fees to investment-related expenses. Over the course of a career, the fee differential alone can make a significant difference in investment outcomes.

The more subtle benefits include:

5. Greater beneficiary flexibility: You are not required to name your spouse as your IRA’s beneficiary, and you have far greater latitude in who you can name. With 401(k)s, you must name your spouse as your beneficiary if you are married or have your spouse authorize an alternate beneficiary.
6. Simpler RMD procedures: With IRAs, if you have multiple IRA accounts, you can aggregate them and take a single distribution from the most convenient account(s). With multiple 401(k)s, you must take the proportional distribution from each plan.
7. No RMDs for Roth IRAs: No RMDs are required if you have Roth IRAs, but they are required if you have Roth 401(k)s.
8. A QCD, or Qualified Charitable Distribution: Your annual RMD from IRAs can be satisfied by directly transferring up to $100,000 from your IRA’s custodian to a qualified charity, income-tax free. What you distribute as a QCD can be excluded from your taxable income, which is not the case with a regular RMD. And you can still claim the standard deduction that same year.
9. More options for penalty-free early withdrawals: With a 401(k), you can withdraw funds penalty-free if you retire between the ages of 55 and 59½. But with IRAs, you can avoid the 10% penalty if funds are used to purchase a first home, support you if you are permanently disabled, or pay for college, adoption, or certain health insurance premiums.²
10. A pre-59½ annuity option: An IRA allows you to take a series of substantially equal periodic payments (SEPP) for your (and your designated beneficiary’s) life or life expectancy without paying penalties, despite not having reached age 59½.³

Which Option is Best for Your 401(k)?

That answer depends on your personal and financial circumstances. In most situations, the benefits of rolling your 401(k) into an IRA outweigh any benefits of leaving your 401(k) with your ex-employer. But whether you roll your 401(k) over into an IRA, move it to your new employer’s plan, or leave it with your ex-employer, it is important to keep that accumulated money in a retirement-specific account—doing otherwise may put your retirement at risk.

Financial planning decisions can be complex, and mistakes can take a bite out of your hard-earned retirement funds. If you want to make sure that you are on track for a successful retirement, schedule a no-cost initial meeting with one of our financial advisors at Capital Advantage, Inc.

^Sources:

1. MarketWatch. “Opinion: Americans are leaving old 401(k) accounts behind – and paying the price.” https://www.marketwatch.com/story/americans-are-leaving-old-401-k-accounts-behind-and-paying-the-price-11627055031 marketwatch.com (July 24, 2021).
2. Internal Revenue Service. “Topic No. 557 Additional Tax on Early Distributions from Traditional and Roth IRAs.” https://www.irs.gov/taxtopics/tc557 irs.gov (May 19, 2022).
3. Internal Revenue Service. “Topic No. 557 Additional Tax on Early Distributions from Traditional and Roth IRAs.”