It’s that time of year when people are thinking about money, because I’ve been getting lots of e-mail lately along the lines of, “Hi Luxe, what would you do if…”
I start hammering out a reply, but then I think, hey, I bet other readers are wondering about this same thing. So today I’m test-piloting an ‘Ask Luxe’ series. In my regular posts I can only give general advice or speak through my own experiences, but not everybody has the same circumstances as me, and I think the best way to learn is through a variety of real-life examples.
And this one is a really, really good one to learn from.
Today’s question is from A, who’s wondering what to do with her old 401k:
“I made changes to my 401K after reading your advice and using a meeting with a free financial planner at the NYPL (would definitely suggest this to readers! It’s a real financial planner who donates their time for a free one-time meeting to help you set financial goals). Anyway, we made several changes and nothing I invested in had a fee of over 0.1%. From my understanding, my 401K was decently lucrative and had some good options.
Anyway, my company was recently acquired and we’re switching plans. The new plan is NOT as generous. I’m planning to go with the target fund since it’s in the same realm of fees as everything else and I definitely want my match and to keep investing.
BUT-what do I do with my old 401K? I’m hesitant to roll it over into this new plan because I don’t want to jeopardize my gains with high fees.
What would your advice be for someone trying to decide whether to leave something in an old employer 401K: roll it into a new, less lucrative plan, or put it into an IRA?”
Since so many of us are switching jobs every few years, I thought this would be a great question to answer.
Per the usual disclaimer, I am not a financial expert or a tax professional, so please do outside research and consult professional resources before making any financial decisions. Don’t take my words at face value!
By the way, if you want me to answer a money question I need WAY more personal information than you ever thought possible, like basically your mom’s cellphone number.
So I followed up and got more info. Here’s what A told me:
- I’m 24 and I’m getting married in December.
- Income: this year I made $65,000 with a $5,000 bonus. Next year this will increase to $68,250 with a $10,000 bonus.
- Approximately $22,900 in the old 401K plan.
- I’ve called the old 401k company and they said we’re allowed to keep that account with all the same fees for 6 months. After that period, the 401K will automatically be rolled over to a random IRA company, which I would then have to claim.
- Any contributions I make starting January will automatically be routed into the new 401K with a 4% company match. This last year I contributed 12% with a 3% match (the match is going up in the acquisition). This year I was planning to contribute 16% and get the 4% match, though with fees it could be better to reroute the percent I contribute beyond the 4% for the match into an IRA.
- No other investment accounts open.
- I’m only planning to stay at my current company until June 2019, and am heading back to graduate school in the fall.
- With the new 401k, I plan on investing in the target fund option, which has an expense ratio of 0.76%.
My Initial Thoughts
- Yes, everybody should investigate free financial resources at their local library! Just be wary of any kinds of services they might be trying to sell you.
- A was super smart and proactive when she asked about the fees involved with leaving the 401k in the old account. I’ll admit, I’ve left old 401ks orphaned for way too long out of sheer laziness.
- No Roth IRA?
Then I saw the grad school detail and I started seeing dollar signs.
But after that I saw the 2019 wedding and worried that might complicate things.
We’ll talk about those details later.
Things to Consider
Choosing what to do with an old 401k is usually pretty straightforward, but you’ll see below how things like taxes, the amount that’s currently in the 401k, and life events can all be important factors in how you decide.
These are the questions I asked A, and are a good starting point if you’re faced with a similar situation:
- How much money do you currently make? Are you married? If yes, what’s your partner’s income?
- What other investment accounts do you have open? And how much do you contribute to those accounts?
- How long do you plan on being at this job?
- What’s spread between the fees for the new 401k plan options, and the old one 401k?
- How much do you currently have in the 401k, and what’s the employer match?
- What are the fees involved with just letting the 401k sit in the old plan?
Five Ways to Handle an Old 401k
A asked about two of the most common options for handling an old 401k when you leave a job, but I’m going to mention a few other scenarios, and why one might consider them.
1. Do nothing
If you have at least $5,000 in the old 401k account, then you should be able to leave it there…but beware of the consequences.
Pros: It’s way less work. And if you’re perfectly happy with the performance and the fees, why fix what’s not broken? If you don’t like the 401k plan at your new company, letting the old money sit as-is can buy you time until you find a company with a better 401k plan.
Cons: The old plan might charge you extra administrative fees if you’re no longer an employee at the company (ask!). You most likely won’t be able to make changes to the account anymore, like rebalancing or adjusting risk allocation as you get older. It’s also easy to lose track of an old account years later and have to jump through hoops to even find out how to take hold of your money.
Thanks to A’s due diligence, she found out she can only leave the money in the old account for 6 months fee-free until it’s rolled into a pre-chosen, most likely sub-par IRA account. I also bet you a million dollars that you probably have to pay fees to claim the money, too. Moral of the story is, make sure you understand the timelines and fees of doing nothing with your old 401k money.
2. Roll over the old 401k into a new 401k
If your new company offers a 401k plan and accepts rollovers, you can consolidate accounts by rolling over your old 401k balance into the new one.
Pros: If you value simplicity, then managing just one 401k account might be appealing.
Cons: You might not like the investment options or the fees associated with the new account.
A has properly vetted the options for the new 401k plan, and she’s concerned about the higher fees.
In my post about how I choose my 401k funds, I mentioned looking for options with low fees.
I said that fees add up over time. That is true. But over a span of years, not 6 months.
I’m not sure what the increase in fees is with the new account, but I’m going to guess it’s 0.5%. So in A’s specific situation, the 0.5% increase in fees wouldn’t be a significant factor for me.
Considering many people stay at their companies for about 2-3 years, a 0.5% spread in fees is temporary and can usually be overcome by an employer match and tax breaks. Regardless, let’s do the math: 0.5% of $22,900 is only an extra $114.50. Could she live with that? But if the fees in the new plan was something like 3%, then I’d be concerned.
And while most people can’t predict how long they’ll stay at a job, for A there’s an end date. She’ll only be at the “new” company, and dealing with the higher fees, for about another 6 months before she heads off to grad school.
So how do figure out how fees are affecting your gains without having to whip out a calculator? What I do is have my investment accounts linked up to Personal Capital (kind of like Mint, but for investments), because they have this neat retirement fee analyzer tool. It adds up all the fees across all your investment accounts, gives you the dollar amount you’re paying each year, and shows you a graph of how the fees might add up over time. You can sign up for free here (affiliate link).
3. Roll over the old 401k into a Traditional IRA
The self-directed option is to roll the 401k balance into an existing Traditional IRA account at a place you choose, like Vanguard, Fidelity, Schwab, etc. If you don’t have a Traditional IRA account already, you have to open one up first, then request a ‘direct rollover’ or ‘trustee-to-trustee transfer.’ Be extra careful to follow the instructions exactly.
Pros: With 401k funds, you’re usually limited to about 30 options that might not be great, and are often charged higher fees. But in a Traditional IRA, you have the ultimate control: you get to choose basically whatever you want, and the fees will generally be lower, too.
Cons: If you end up being a high earner in the future, and plan on retiring early, money in an existing Traditional IRA account can complicate advanced strategies like the Backdoor Roth IRA. My friend Adam wrote a post that explains why you might want to think twice about rolling over your 401k into a Traditional IRA.
This is a popular choice, and one I’ve always opted for myself. I liked having full control of my own accounts and having a buffet of investment options that my 401ks never offered.
However, I’ve found myself in the exact ‘con’ situation I described above. I had rolled over 401k balances from 2 or 3 jobs and amassed a sizeable balance in my Traditional IRA account. I also had another IRA I contributed post-tax money to, a Roth IRA, and maxed that out every year I could when I was single.
But then I got married.
All of a sudden our combined income disqualified me from contributing to my Roth IRA account. The only way I’m allowed to do it now is by using the Backdoor Roth IRA strategy. The simplest, cleanest way to do it is to have a Traditional IRA account that has $0 in it, contribute new money to it, then convert that money to a Roth IRA. My Traditional IRA account unfortunately already has lots of dollars in it. So I have to get rid of those dollars by rolling them over to a 401k plan that allows rollovers. Hello, extra paperwork and hassle. Paperwork breeds inertia, because so far I haven’t done it yet.
4. Roll over the old 401k into a Traditional IRA, then convert it to a Roth IRA
Converting your old 401k balance to a Roth IRA is a two-step process, but can be well worth it, depending on your circumstances. If you want to know why I have both types IRA accounts, and the difference between each, check out my investing hierarchy post.
Pros: A Roth IRA is more flexible than a Traditional IRA or 401k, and the money grows tax-free. The contribution limits for a Roth IRA is $6,000 in 2019, so doing a conversion of a larger amount can be a strategic way to fast-track your balance.
Cons: You have to pay taxes on the amount you convert from the Traditional IRA to the Roth IRA. Do you have thousands of dollars laying around to pay them come tax time? This option can definitely be prohibitive for those in higher tax brackets.
A makes $65,000 a year, which puts her in the 22% tax bracket. When you convert a Traditional IRA to a Roth IRA, you not only have to pay taxes on the balance, but that balance counts as taxable income, too. So, the $22,900 increases her taxable income to $87,900, and she’d owe about $5,146 in taxes to do the conversion. Good lord, that’s a lot of money.
If you’re wondering if a Roth IRA conversion makes sense for your situation, here’s a calculator that will help you figure out the estimated taxes you’d owe, and how much your money might grow over time versus a Traditional IRA.
5. Cash out the 401k balance
Pros: Cash is king. Some of us come up short when it comes to bills we have to pay, and cash on hand can temporarily relieve a lot of stress.
Cons: You’re robbing Future You of any potential compounding gains. And if you’re younger than 59 1/2, you have to pay a 10% early withdrawal fee, plus income taxes on the distribution.
Everyone will tell you that this is a flat-out no-no, but I think it depends on how much money you have in the account. My thoughts: this isn’t the worst option if you have a small amount of money in the old 401k, like a couple thousand bucks, but A has over $22k in there, so…
What I Would Do
For most people, rolling over the money to a Traditional IRA or a new 401k plan is going to meet their needs just fine.
- A Traditional IRA could be a good idea if you don’t mind DIY investing for more fund choices and lower fees.
- A new 401k plan could be a good idea if you want to streamline accounts and don’t mind limited options and possibly higher fees.
But A has three life events that make her situation unique. Let’s recap the timeline:
- June 2019 – Leaving her job
- August/September 2019 – Starting grad school
- December 2019 – Getting married
If I were in this situation, assuming I would be future grad school student making little to no money, I’d research how I could make option 4 happen, converting the money to a Roth IRA.
I love my Roth IRA.
And A currently doesn’t have one. But if the stars align, she now has an opportunity to have a Roth IRA with over $22k in it at only age 24.
Being stalled at a lower income is nothing to celebrate, but there are definitely some silver linings.
In this case, it’s taxes.
I asked A about her future husband’s salary. It turns out he’s a law student who will be looking for a job in the fall. They are also getting married in December 2019. The funny thing I’ve discovered is, the IRS counts you as married the entire year. So, even if they get married on December 31, 2019, the IRS counts them as married as of January 1st, 2019.
So for all of 2019, A’s tax situation is changed. As I mentioned before, A is currently in the 22 percent bracket as a single person in 2018. But in 2019, she has the potential to drop down to the 12 percent bracket, if her and her future husband’s taxable income doesn’t exceed $78,950.
As a single person working her full-time job, A would have had to pay over $5,000 in taxes to do the Roth conversion. But the marriage event and both people working just half the year could mean she might only owe $2,798 instead. A and her husband could also help reduce their taxable income by contributing aggressively to their 401Ks.
Considering how well A is doing right now, and how her husband is going to be a lawyer, they might never be in that low of a tax bracket ever again. So, I’d crunch the numbers. And I’d want to consult a legit financial professional to make sure I follow all the rules, if I went down this route.
Although no one knows what future tax rates are going to be, this calculator can at least help you get a sense of what your tax bill might look like if you did a Roth conversion today.
Readers: If you were in A’s situation, what would you do and why? Roll the money into an IRA, roll it into the new 401k, convert to a Roth, or something else I’m not thinking of? What have you personally done with your own old accounts?
Feature Image: Unsplash