When meeting with clients about their financial assets, it is very common to hear something like “I’ve got a few 401(k)’s laying around from previous job”. 

If that’s you too…don’t fret.  It’s pretty easy to fix.  You can do it yourself if you like.

First thing to know is that they money in old 401(k)’s will always be yours.  You haven’t lost anything.

But we do recommend clients roll old 401(k)’s into an IRA (roth or traditional depending on their income levels), or simply roll it into their current 401(k) if they have one.

Reasons Not To Leave Your 401(k) With Previous Employers

A few reasons really.

First, it is cumbersome and costly to have investment accounts scattered across different platforms.

Each investing platform has their own fee structure, meaning that you could be paying fees unnecessarily with no added benefit.

Second…many people just prefer to have their investments consolidated.  It provides a clearer picture of your overall portfolio when everything is on one statement (though our clients have access to a system that will consolidate all their accounts in one dashboard).

It’s just more convenient.

When investing in your 401(k), there is very little choice you have in where your money is invested, and how it is invested.

You may get a choice between a few mutual funds when you set up the plan in your first week with the company.  And it is very unlikely you received much in the form of professional investment advice when choosing the mutual fund.

With a 401(k), you have the administrative costs, on top of the mutual funds costs.  When you take into account that very few mutual funds “beat the market”, it is very possible you are paying higher than normal fees for sub-par returns.

The 401(k) Rollover

The 401(k) rollover is simply a method of moving your 401(k) at your previous employer into a new retirement account.

You can move your 401(k) into an Individual Retirement Account (IRA), or…if your new employer has a 401(k) option…you can roll it into your current employer’s 401(k) option.  Each option has its benefits and restrictions.

401(k) Rollover into New Employers 401(k) Program

If your new employer offers a 401(k) plan, you can request the plan administrator to transfer your old 401(k) assets over to your new one.  Not all plans offer this, but it may be an option.

The advantages of this method is it is a fairly simple process.  Usually your new plan administrator will give you a form to fill out and they handle the rest.

Another advantage is your tax deferred growth continues to grow tax deferred.  This is one of the big benefits of a 401(k) (and many retirement plans)…that growth is not taxed until you withdraw your money.

Another possible advantage would be if fees are less in your new 401(k) plan than in your old plan.  If this is the case, it would make more sense to do a 401(k) rollover into your new 401(k) plan.

However, fees may be greater on your new plan…so it’s important to check that.  But no matter what, fees are always a consideration in any investment strategy.

Another consideration with a 401(k) rollover into another 401(k) plan is the limited investment options.  Most 401(k) plans only offer a limited number of investment options.  It is likely that you can find one option that would be “suitable” but perhaps not your best option.  Plus…the available mutual funds may have higher fees than you are comfortable paying.

When you take into consideration that you must judge the appropriateness of the fee structure (which is usually hard to understand) or limited investment options with guidance from someone usually in the HR department (not a qualified financial advisor)…it may be prudent to look into your other options. 

401(k) Rollover into an Individual Retirement Account (IRA)

Within the option of a 401(k) rollover into an IRA, may have two options depending on your income level.

401(k) Rollover into a Roth IRA

A Roth IRA is a wonderful option…so much so that the government imposes strict limitations on the account contributions and eligibility.

Roth IRA Eligibility:

Single people or married couples filing separately can open a Roth IRA if their earned income is less than $135,000.  If you are married, filing jointly, the income eligibility limit is $199,000 (as per 2018 IRS rules).

If you make more than that, you are ineligible for a Roth IRA.

Many younger people begin looking at retirement account options and believe that if their future income level is expected to be greater than $135,000 (if single), that they should take the traditional IRA account option (which doesn’t have income eligibility requirements).

There is nothing that precludes someone from having a Roth IRA and a Traditional IRA.  And since the two accounts are taxed differently, it may be prudent to utilize both while you can.

Roth Contribution Limits:

Since both Roth and Traditional IRA’s give certain tax benefits…the IRS limits the amount of money that can be contributed to these accounts.

For both Roth and Traditional IRA’s, you can contribute up to $5,500 per year.

Both have a “catch-up” provision, allowing people age 50 and over to contribute up to $6,500 per year.

Roth IRA Taxation:

In a Roth IRA, you are funding the account with post-tax dollars…meaning you pay taxes on that money in the current years (no deductions on your income tax filing).

The money grows tax deferred (meaning you are not taxed on the growth).

And since you paid taxes on that money already, you can pull the money out at retirement tax free.

If you have to pull money out before age 59 1/2, there will be a 10% tax penalty except for qualifying expenses.

Qualifying expenses include:

  • First Time Home Purchase (up to $10,000 lifetime max.)
  • Qualified Education Expenses
  • Disability
  • Qualifying Medical Expenses
  • Substantially Equal Periodic Payments

If someone believes they will be in a higher tax bracket at retirement, usually due to loss of deductions while maintaining their lifestyle, maxing Roth IRA contributions might be a solid strategy to employ.

Roth IRA Withdrawal Rules:

By age 59 1/2, withdrawals can be made tax free and penalty free as long as the account is at least 5 years old.

A Roth IRA has no required distributions age.  So if you never needed the money, it could be left to your designated beneficiaries.  This is one of the important distinctions between a Roth IRA and a Traditional IRA.

401(k) Rollover into a Traditional IRA

A Traditional IRA works in much the same way as a Roth IRA…with a few key differences.

Traditional IRA Income Limits:

There are no income limits for a Traditional IRA.  So weather you make $30,000 a year or $300,000+ a year, you can qualify for a Traditional IRA.

Traditional IRA Contribution Limits:

As stated previously, both Traditional and Roth IRA’s have contribution limits.  For both, the limit is $5,500 per year with a “catch-up” provision for people age 50 and older to contribute up to $6,500 per year.

Traditional IRA Taxation:

Traditional IRA’s allow for contributions to be made “pre-tax”, meaning contributions are deducted from income on your tax returns.

This reduces the current year’s taxable income by the amount contributed to the Traditional IRA…much the same way your 401(k) is taxed.

The growth in the account is tax deferred…meaning there is no taxation while assets are accumulating.

But you will be taxed on your withdrawals as ordinary income.

If someone believes they will be in a lower tax bracket in retirement than they are today…a traditional IRA would be best suited.

Of course we cannot be certain what tax rates will be in the future.  There is a strategy many of our clients utilize to minimize tax risk.

Traditional IRA Withdrawals:

Money can be withdrawn penalty free after age 59 1/2.  If you need to withdraw money before that age, there is a 10% penalty assessed on your taxes.

Unlike the Roth, the Traditional IRA has a mandatory age at which you must begin taking withdrawals.  Even if you don’t need the money, the IRS requires all Traditional IRA account holders to begin taking withdrawals by age 70 1/2.

So which is better…a Traditional or a Roth IRA?

As my college economics professor once stated, “the answer to every question is…’it depends'”.

I always found that answer to be frustrating… but luckily…it’s not that complicated.

If you think you will be in a lower tax bracket, or taxes rates will be lower in the future…a Traditional IRA is a good bet.

If you think you will be in a higher tax bracket or that tax rates will increase in the future…it may be better to go with a Roth IRA and “take the haircut” today.

Of course, if you make over $199,000 as a married couple (or $135,000 single), it doesn’t make any difference.  You would not qualify for a Roth IRA.

When investing, most people focus solely on the investments…what is going to give them the best return for an assumed level of risk.

And though that is critical, if people start out with the wrong account type to begin with…they are starting their journey in a boat with holes in it!  And when talking about retirement planning…a leaky boat can add years to your retirement date.

At Orange County Wealth Management, we focus on making your investments as tax efficient as possible from the start.  Then we look at what investments will get you to where you want to go.

You can do a 401(k) rollover yourself…it’s not difficult to do and there are plenty of tutorials on the web to help you accomplish this.

If you don’t want to DIY your retirement planning, click below to schedule a complementary strategy session.  Everyone receives a free financial plan weather they become a client or not.

Why would we do this?

Simple…we hope you become a client.  And if you don’t…that’s okay.  You will still walk away having a good experience with us, and a basic financial plan to give you the confidence that you can achieve the retirement you desire.