There once was a time when people worked the same job their entire life and retired with a pension. Now? Not so much. Instead, most people work multiple jobs during their lifetime, and their retirement is funded by money accrued in their 401(k).
So… When you switch jobs, what should your old 401(k)?
Don’t cash it out
First and foremost, do not cash out your 401(k). Tax-deferred savings accounts are hugely valuable in the long run, and unqualified distributions will result in both taxes and penalties. This is a bad, bad thing and should be avoided at all costs.
Consider leaving it alone
Perhaps the easiest thing to with your old 401(k) is to simply leave it alone. If you’re happy with your investment alternatives, and your former employer will allow it, you might just want to leave it in place.
This can also be a useful strategy if your new employer has a waiting period before you’ll be eligible for their 401(k) plan. Once the waiting period is up, you’ll be free to roll the money into the new plan — assuming that the new plan accepts rollover contributions.
Roll it into your new employer’s plan
Another potentially attractive option is to simply roll your 401(k) balance into your new employer’s plan. Not all 401(k) plans accept incoming rollovers, but if yours does, then consolidating the money would simplify your financial life. Of course, there are other considerations here…
Are you happy with the investment choices? What about the fees and other expenses? While you will likely want to participate in the new plan, at least to get any matching funds that might be available, you might not want to move additional money into it.
Roll it into an IRA
The big problem with 401(k) accounts is a lack of control when it come to investment options and expenses. While there are some really good 401(k) plans out there, many others are really, really bad. The investment choices stink, they’re laden with fees, and so on.
When you change jobs, you have an opportunity to roll the money into an IRA, choose your own broker or mutual fund family, and really take control of your investments. In most cases, this is a very attractive proposition, and you should seriously consider doing it.
There are a few other considerations to keep in mind when deciding what to do with your old 401(k). For example, you’re allowed to borrow against your 401(k) balance, but you cannot borrow against your IRA. I’m not a fan of borrowing from your retirement plans, but it’s a difference worth mentioning.
Conversely, with an IRA you can withdraw money at any time for any reason. Yes, you’ll pay taxes and penalties, but you can do it. With a 401(k) you’ll have to meet specific hardship guidelines before you can touch the money early.
Another point is that, once you get the money out into an IRA, you have the option of converting some or all of it into a Roth IRA. Conveniently, the income limits for Roth IRA conversions have just gone away. Yes, you’ll face taxes when you convert deferred money into a Roth, but it may be worth it depending on your circumstances.
While we’re on the subject of Roth IRA conversions, however, there’s a downside to moving your 401(k) money into a traditional IRA. If you’re over the income limits for contributing to a Roth IRA, you might be tempted to make non-deductible contributions to a traditional IRA and then convert the money into your Roth.
The problem is that, if you have tax-deferred money in an IRA (traditional, SEP, or SIMPLE), you’ll have to factor that in when determining the tax status of your conversion. Here’s a snippet from Fairmark.com that I’ve previously used to illustrate the problem:
â€œFor example, if you happen to have a traditional IRA with $96,000 of money from a 401k rollover (zero basis) and you make a $4,000 nondeductible contribution to a new IRA, thinking you can convert it to a Roth at little or no cost, youâ€™ll be wrong. You have to add the two IRAs together to determine the taxable amount, and in this case your conversion will be 96% taxable.â€
The workaround here is to simply keep your 401(k) money in a 401(k), Alternatively, if you have money in (say) a SEP-IRA, you may be able to roll it into your employer’s plan, or perhaps a solo 401(k) to avoid the pooling of funds mentioned above.
In some ways, the solo 401(k) gives you the best of both worlds, as you get freedom to choose your own brokerage and slate of available investments while still shielding the money from the unfortunate tax calculations associated with a Roth IRA conversion.
Of course, as noted above, you also lose the ability to withdraw funds on a whim, and there is an extra form that you’ll have to file at tax time once your solo 401(k) balance reaches $250k.