A new client recently remembered she had a 401(k) balance with a former employer’s retirement plan. After investigating, we discovered she had four different 401(k) plans, each with a different employer. Her current employer has a 403(b) that she is contributing to with each paycheck. What should she do with these four old plans?
You have several options with most workplace retirement plan accounts once you are no longer an employee. 1) Cash it out, 2) Leave it in the existing plan (if the employer allows), 3) Transfer it into your new employer’s retirement plan (if one exists and the plan permits rollovers), or 4) Roll it over into an individual retirement account (IRA). Here are the pros and cons of each of these options:
- Cash it out- This is rarely the best choice. Even if you’re in extreme financial hardship, it is usually not a good idea to withdraw your retirement savings unless you have exhausted all other options. Withdrawals are subject to income taxes and the plan is required to withhold 20% for taxes when a plan is cashed in. There are penalties for taking the money out of a retirement plan if you are under age 59½. Even if you qualify for one of the 10 penalty exemptions, there are still income taxes to pay. Leaving the money in a retirement plan to grow tax-deferred until retirement will most often be a better choice.
- Leave it in the existing plan – Some workplace plans do not allow former employees to leave their money in the plan. Small balances are rarely allowed but a plan may permit it as long as the account value meets a certain dollar threshold. You may be tempted to leave the account alone if performance is good and expenses are low. However, there are benefits to consolidating investments. Just keeping track of these accounts can be burdensome. It can quickly become a nightmare if someone else needs to take over your affairs.
This leaves us with what may be the two best options for an old workplace retirement plan. Deciding which of these two options is best will require careful consideration.
- Transfer it into your new employer’s retirement plan – The first step is to find out if the new employer’s plan accepts rollovers. My client wanted us evaluate moving money out of a 401(k) plan and into a 403(b). These types of rollovers are permitted under the law, but it is ultimately up to the plan whether it is allowed. You certainly want to review investment options and expenses of the new employer plan, but there are other important considerations to think through.
- Loans — Loans are permitted against most workplace plans provided the plan allows them. A loan can be taken for (1) the greater of $10,000 or 50% of the vested account balance, or (2) $50,000, whichever is less. You can’t borrow from an IRA or pledge an IRA account as collateral for a loan.
- Earlier penalty-free withdrawals — IRA account owners must wait until age 59½ to access funds without penalty. Funds can be taken from workplace retirement plans penalty-free starting at age 55 if you leave your job.
- Protection from creditors – Workplace retirement plans have unlimited protection in bankruptcy court and against creditors’ claims. IRA owners have maximum protection of $1,362,800¹. Each state may limit creditors’ claims on IRAs.
- Still working exception – Withdrawals from an IRA must begin at age 72 whether you are still working or not. However, you don’t have to begin distributions from a current employer’s retirement plan until you retire.
- Backdoor Roth and the pro-rata rule – Taxpayers with higher incomes cannot contribute directly to a Roth IRA. They can make non-deductible contributions to an IRA and immediately convert them to a Roth. This technique has no tax consequences unless there is already pre-tax money in one of your IRA accounts.
- Net Unrealized Appreciation (NUA) – Anyone who holds company stock in a 401(k) could lose out on a big tax break if they roll the stock to an IRA. The NUA strategy allows the stock to be transferred to an after-tax account with tax due only on the cost. The appreciation is taxed when the stock is sold but at the lower capital gains tax rate. More information on this technique can be found at 5 Steps to a Successful NUA transaction.
- Roll over into an individual retirement account (IRA) – Some of the top reasons to roll over into an IRA are more investment choices, better communication, the potential for lower fees, and more control.
As you can see, there are many consequences to consider before deciding which option is best for your unique circumstances. A lot will depend on the specifics of your new employer plan. Rollovers to a new workplace plan or an IRA are certainly a better option than cashing out, which just might be the worst thing you can do with a workplace plan account. However, moving money from an old workplace retirement plan to either an IRA or the new workplace plan requires careful evaluation if you want to make the best choice.
- Cashing out a workplace retirement account will be subject to income tax and may often have tax penalties.
- Loans are often permitted against funds held in a workplace retirement account but are subject to some limitations.
- IRA account owners must wait until age 59½ to access funds without penalty.
1 The current limit provided by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This limit is adjusted for inflation every three years (the next adjustment will be in 2022)