Like divorcees who just can’t let go, tens of thousands of people leave their jobs each year without taking their 401(k) balances with them.
Job-switchers and retirees leave an estimated $40 billion each year in former employers’ retirement plans. For most of them, it’s not because they’ve carefully considered the costs and benefits of their options. It’s a simple case of inertia.
Employees have three options when they leave a job where they’ve accumulated a 401(k) balance:
Here, we’ll discuss the pros and cons of each option:
Leave your money in the plan. If the employer allows it (most do), the departing employee can simply do nothing, and his or her money will remain in the account.
A major benefit of this option is that penalty-free withdrawals may be made from 401(k) plans as early as age 55 (the age is 59 ½ for IRAs). Another: Since the 401(k) is covered under the federal ERISA, it enjoys a statutory protection from the claims of creditors. In many states, though, including Illinois, case law has determined that IRAs also enjoy this protection.
The 401(k) may have cost-efficient investment choices available. On the other hand, the 401(k) may include many expenses that aren’t readily visible to the account holder. An assessment of expenses is an important consideration in deciding whether to leave money in an employer’s retirement plan.
Leaving money behind in a 401(k) can have disastrous results. The case of Penn Specialty Chemicals is a particularly scary one. The Memphis company declared bankruptcy, and although the assets of its 401(k) were supposed to be transferred promptly to employees, they weren’t. It took five years for the employees to get their money, and their accounts were charged administrative and legal fees in the meantime. Penalties were assessed against some former employees who couldn’t take mandatory distributions from the plan when they reached age 70 ½.
This is admittedly an extreme case, but it shows what can happen when you leave your retirement funds under the control of a former employer. Most people want a clean break when they leave a job.
In our opinion, rolling assets from a former employer’s 401(k) plan into a new employer’s plan is not a good choice, either. Once funds are in the plan, if allowed, money can be borrowed out, but that’s usually not a smart financial move, anyway. Also, distributions are not required at age 70 ½ if the employee is still with his or her company. This is not much of a plus for most people, though, because few intend to work beyond that age anyway.
Transfer your plan assets to an IRA. This is usually the preferred choice. It results in maximum flexibility and maximum control, and there is no concern about a former employer creating problems. For most people, the ability to take penalty-free withdrawals at age 55 is not a big benefit.
Once the assets are in an IRA, they can be converted to a Roth IRA if that makes sense. A full range of IRA investment choices is available, including stocks, bonds, ETFs and mutual funds. Costs and fees are transparent in most cases, although the investor should still do his homework to make sure there are no hidden costs.
Once in the IRA, the funds can also be converted to a guaranteed lifetime stream of income through the purchase of an immediate fixed annuity. A partial or full withdrawal of the funds can be made without tax or penalty, as long as the funds are rolled back into the same IRA or a different one within 60 days.
Withdraw your money from the plan. This is the least desirable option, as it would result in taxes, and penalties in the event that the account holder is younger than 55. Of course, if the account holder experiences a lengthy period of unemployment or other financial catastrophe, there may not be any choice but to withdraw. Rolling a 401(k) balance into an IRA first, though, would allow the timing of withdrawals to meet cash-flow needs and to minimize income tax impacts.
Stockbrokers are often criticized for recommending that clients roll their 401(k) balances into IRAs, solely for the purpose of putting them into heavily loaded mutual funds or insurance contracts. Advisers with Mentor Capital have no such conflict of interest, because our fees already take 401(k) balances into account. We have no particular incentive to encourage a 401(k) rollover to an IRA, other than that it is usually in the client’s best interests.