Thanks for coming back for the latest edition of Planning for your Purpose; Telos Financial’s blog where I discuss different topics related to financial planning. CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy is Plymouth, Michigan’s financial advisor serving clients throughout the mitten as well as across the country.
The primary purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions about that will educate, benefit, and improve your financial life. Ultimately, to help you focus on your telos!
What do I do with my old 401k account?
This is one of the most common questions I get asked. When you’re working at a company, you’re saving to a 401k, hopefully getting a match from your employer, hopefully you have the account invested to match your risk tolerance and risk capacity and so the investment allocation is aligned with your goals. When you leave, you may feel confused or bereft of knowing what to do.
Basics of an Old 401k
First, let’s talk about what the 401k is and the savings in it. The vast majority of 401k assets are classified as Pre Tax or Traditional, meaning when you put the money into the account, you didn’t pay income tax. That means most of the money in 401ks will be taxed as ordinary income when it comes out. If you’re under 55 and you withdraw the funds, you will most likely have to pay a 10% penalty on top of the income tax.
The balance in your 401k account can also be after tax or Roth. We’ll leave that aside for now, but understand it’s really important to know the tax location of the assets.
When you leave the company, you will still be able to change investments in the account and the balance will continue to fluctuate as the investments do. So, you don’t want to just forget it, you need to periodically monitor it and review as part of your holistic financial plan.
You have several options on what to do with your old 401k. There are a lot of things to consider when making this decision, so it’s important to know your priorities, what you’re trying to accomplish, as well as details of the plan. You need to know the fees associated with the current account as well as any other accounts, fund fees, transaction fees, investment options, ease or difficulty in managing the account, among other factors.
Leave it. You can just leave it where it is. You need to know if there are fees associated and you want to make sure there are investments that align with your risk tolerance. The biggest benefit is this requires the least effort from you as it’s kinds the default option. The biggest downside to this is it’s one more user id and password you have to remember and you have to monitor it to make sure the investments are good.
Roll it. You can roll your old 401k to an IRA or a new 401k, 403b, or similar account. Doing a direct rollover or proper indirect rollover will make sure you don’t have any tax or penalty associated with the move. The biggest benefit to rolling (typically) the account is consolidation. You won’t end up with a bunch of retirement accounts all over the place that you have to manage. The biggest drawback to rolling I typically see is fees are generally higher outside of 401k plans, though not always. Aside from management fees, there are investment internal costs, and administrative costs.
You need to make sure you maintain the tax classification of the rollover, Roth to Roth, Traditional to Traditional, and After tax to After tax (you may be able to go after tax to Roth, so make sure you understand your options). You also need to make sure you either do a direct rollover, or follow the rules related to indirect rollovers.
Cash it. You can pay the tax, pay the penalty (if applicable), and take your money to spend now. This is only attractive if you really need cash now and the long term prospects of the account aren’t ideal.
Cashing in your 401k is a short term decision. It’s most likely going to be necessary if you unexpectedly had to leave your job, don’t have savings to support your lifestyle, and don’t have another source of income to replace it. There probably are other circumstances where it would be wise to surrender your old 401k account early, but in the majority of cases, it probably doesn’t make sense to pay the extra penalty and do this.
Your former employer and plan may somewhat guide the decisions related to this. You may have limitations, depending on the plan type, related to these three options. For example, if you work for the University of Michigan and have a 401a account, you cannot transfer this. The only options are to surrender it or leave it with their investment custodian. Most employers don’t have limitations on these plans, but be aware that some limitations exist.
Exemptions to the Penalty. There are some situations where you can make an early withdrawal from your 401k without paying the penalty. These are for very specific hardship scenarios including large medical expenses, a first time home purchase, disability, and college tuition. If you are curious if an exemption might apply to you, talk with your CPA, tax professional, or financial professional. If you’re a DIYer, make sure to read the IRS code section on early withdrawal penalty exemptions.
If you are eligible for a waiver from the penalty, remember, you will still be liable for the income taxes on the distribution. So, tax withholding, estimates, or a bigger bill at tax time needs to be part of your calculation.
The bottom line here is if you have a 401k, 403b, 457b, SIMPLE IRA, or other retirement savings plan at a former employer, PAY ATTENTION TO IT. You don’t need to watch it every day, but periodically monitor it. Make sure it’s working for you as hard as it can be. If it’s not, research and consider other options that might be appropriate based on your financial goals and financial plan. Remember you can leave the plan there, roll it to an individual retirement account (with the same tax classification), or surrender it. Make sure you follow the rules with any moves so you don’t get caught in a penalty situation.
If you’d like to discuss your financial situation and options for your old 401k plan, Telos Financial may be able to help you. Contact us today to schedule a free introductory meeting and we can talk more in person. Telos is a financial planning firm serving Michigan’s high income and high net worth millennials, recent college graduates, and small business owners.
Telos Financial is a fee based, holistic financial planning firm located in Plymouth, Michigan serving young professionals and their families. Dennis LaVoy is a Certified Financial Planner® Designee and a Chartered Life Underwriter®. He founded Telos Financial and to provide fiduciary financial services to families across Michigan including Plymouth, Canton, Ann Arbor, Detroit, and as well as all over the great United States of America.
Neither FSC SECURITIES CORPORATION, nor its registered representatives, or employees, provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your own tax or legal counsel for advice.