Questions About Consolidating 401(k) Retirement Savings
You are likely to change jobs 10 to 15 times over the course of your career, based on the national average. Assuming you participate in each of your employers’ retirement plans, you could leave behind a trail of accounts, in addition to having to your own individual retirement account (IRA).
What’s the best strategy for maximizing these retirement funds? Should you consolidate them? Or does it make sense to keep separate accounts?
Here are some common questions regarding 401(k)s and how to manage them.
What Are the Benefits of Consolidating 401(k) Accounts Into One IRA?
There is no one rule for handling your employee retirement funds, but consolidating your 401(k) accounts into a single IRA will simplify your investing now and when you are ready to retire, according to Jamie Hopkins, an associate professor of taxation at the American College in Bryn Mawr, Pennsylvania, and associate director of its New York Life Center for Retirement Income.
Keep in mind that the Internal Revenue Service requires you to begin taking distributions from most IRAs at 70 1/2, so fewer accounts mean fewer mandatory withdrawals.
“Having all different accounts means you would have to take minimum distributions from each one,” Hopkins says. “If you roll them into one IRA, you only have to deal with one account for minimum distribution rules.”
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What Are the Penalties for Cashing Out My Retirement Fund?
Resist the temptation to cash out your 401(k) plan, Hopkins advises. Initially, you will have to pay a 10% penalty if you do not roll over the funds into an IRA, but even more important are the tax and savings advantages of keeping the money in a retirement account.
“Because this amount of money is in a special tax vehicle, and is growing at rates you won’t get anywhere else, a lot of people don’t recognize the value of tax-deferred growth,” Hopkins says.
Expenses of an IRA vs. a New 401(k)
When deciding whether to roll over your 401(k) to your new company’s plan or to an IRA, you should weigh the investment costs.
“A lot of people assume a 401(k) or other qualified plans are free for them,” Hopkins says. “They are not — you pay the fees on the accounts. If you go with a low-cost IRA, the fees can be less than a 401(k) plan.”
Should I Rollover My 401(k) Into an IRA?
In most instances, you are better off rolling over your 401(k) into a traditional IRA, for which you will pay taxes on the monies when you withdraw them, according to Matt Markowski, a principal of Markowski Investments in Tampa, Florida.
However, if you think your tax rate will go up in your golden years, it may make sense to do a Roth IRA conversion, in which you would pay taxes on the amount converted from your 401(k), but the not have to pay them on future distributions.
“It all depends on what you think your tax rate will be in the future,” Markowski says.
Should I Keep My Retirement Money With My Ex-employer?
Instead of rolling over your 401(k) to an IRA, you may opt to keep your retirement money with your former employer. This may be the case if the account charges low fees or if it’s a defined benefit plan that doesn’t allow you to roll it over or cash it out, Hopkins says.
“In most cases, companies want you to take the money,” Hopkins says. “They don’t want to keep the money because it’s an additional cost to them to manage it.”
What Happens to My Retirement Fund if I Retire Early?
If you plan to retire around age 55, you may want to retain your 401(k) plan or keep a portion of your retirement savings in a 401(k), to fill the gap until you can begin withdrawing from your IRA at 59 1/2 without being penalized by the IRS for an early withdrawal, according to Markowski.
“If you plan on retiring early, you need to figure out how much you need each year and multiply it by the number of years until you turn 59 1/2,” Markowski says.
What Is the Financial Impact on My 401(k) if I get a divorce?
If you have a leftover 401(k) account from before you were married, you should consider the community-property ramifications before rolling it over into an IRA, according to Pam Friedman, an Austin, Texas-based certified financial planner and certified divorce financial analyst.
“If you marry and then consolidate, you may have inadvertently co-mingled funds, converting separate property to community property, unless you go through the expensive process of trying to trace the source of funds during divorce,” Friedman says.
Instead, you may want to roll over a 401(k) whose funds were allocated before your marriage to a new IRA account, so that the lines are clear as to which funds are community property and which are separate property, Friedman says.
If I Need Money in a Hurry, Should I Break Into My CD or Borrow From My 401(k)?
Most likely, breaking into your CD is going to be the most cost-effective and straightforward option, though of course, that depends on the specific CD terms. First though, here are two reasons why borrowing against your 401(k) plan might not be the best course of action:
- Loss of tax-deferred earnings. Between the time you borrow from the plan and when you repay the money, the loan balance will be out of the plan. This means that you will miss out on some investment earnings during that period, which is especially damaging since those earnings are tax-deferred.
- Repayment requirement. Loans from a 401(k) plan must be repaid within five years, so you have to ask yourself: If your need for immediate cash is so great, will you have the liquidity to meet that repayment schedule?
You would need to make sure that your 401(k) plan allows loans, and if so under what terms. If you do borrow against your 401(k) balance, it is very important that you do this pursuant to a formal, written agreement. Otherwise, your receipt of the money might be deemed a taxable distribution. That could mean that you would have to pay income tax on the amount of the loan, and possibly a 10 percent penalty.
In contrast, the penalty for early withdrawal from a CD is often just a matter of three to six months of interest. The best CD rates these days are just above 1%, so suppose you have a CD with a 1% rate and face a six-month interest penalty. Effectively, it would cost you about .5% to get out of your CD. If you have had the CD for a while, the penalty might be even less, because some CD penalties diminish over time.
Be sure to check the specifics of your CD before making a decision, but if you really need the cash, a penalty may well be a more cost-effective solution than disrupting your long-term retirement program. This is also a good reminder of the benefit of keeping an emergency reserve in savings accounts or money market accounts, which will make your money more accessible in situations like this.
Should I Put a Lump Sum of Money I Receive Into an Employer’s 401(k) Plan or an IRA?
Generally speaking, a 401(k) plan is likely to be more expensive than an IRA. Still, a more important issue is whether your employer makes matching contributions to the 401(k) plan. Some employers will match, or at least partially match, some or all of the amount their employees contribute to the 401(k) plan. If you are eligible for this kind of matching contribution, it could very well outweigh any fee differential between a 401(k) plan and an IRA.
No Matching Contributions
If your employer does not make matching contributions, then there might be a couple of advantages to putting your money into an IRA rather than a 401(k). One of these advantages is a broader range of investment options. Depending on which 401(k) platform your employer uses, there may be some limitation to the investment choices available to you. Most plans have a range of options ranging from low-risk to high-risk, but you are limited to the options the plan has chosen to make available. In an IRA, you can use any legitimate investment vehicle, from savings accounts to stocks to commodities.
Lower Fee Structure
Another advantage of an IRA may well be a lower fee structure. If you invest in a mutual fund or other managed investment vehicle, you will pay some form of fee, whether it is in a 401(k) or an IRA. On top of that though, 401(k) plans also have record-keeping and administrative fees, which can add another layer of cost.
Still, even if you do your investing via an IRA, be advised that investment fees can vary widely, so look carefully when choosing your investments. That’s not to say low-cost is necessarily the best option — you may well find it worthwhile to pay a little extra for a skilled active manager, but a fee comparison should be one of the factors you consider when choosing how to invest. Also, when looking at mutual fund fees, make sure you check not only the ongoing management fee, but also whether there are any front-end or back-end sales loads.
Annual Contribution Limits
Keep in mind that there are annual contribution limits to both an IRA and a 401(k) plan. If the lump sum you are going to receive exceeds either of these limits, you may want to put some money in both types of plan to take maximum advantage of the tax deferral.
When you leave a job, you also stop investing in that employer’s 401(k) plan. You’ll need to decide how to invest the money in that account.
This decision involves both tax issues and investment issues. An IRA rollover can help you manage the tax side of things and give you options for investing that money.
Often when dealing with an IRA rollover for the first time, people’s instinct is to invest it in something safe and steady like a certificate of deposit (CD) account. However, unless you’re close to retirement, this might not be the best investment for your needs — especially if you were in more growth-oriented investments in your former employer’s 401(k) plan.
What Is an IRA Rollover?
An individual retirement account, more commonly known as an IRA, is not a specific type of investment. It’s a structure that has tax advantages to help you save for retirement.
You can use the money within that structure to invest in a wide range of investments, from CDs and savings accounts to stocks and bonds.
There are two main types of IRAs: traditional and Roth IRAs:
- With a traditional IRA, you don’t pay taxes on money going into the plan nor on investment gains. It is only as the money is withdrawn when you reach retirement age that you have to pay income tax on it.
- In contrast, contributions to a Roth IRA are not tax-deductible, but then you don’t pay any more taxes on that money as your investments grow or when you take money out of the plan upon reaching retirement age.
Basically, IRAs offer you a choice of whether to be taxed now (in the case of a Roth IRA) or when you reach retirement age (in the case of a traditional IRA). People generally base this decision on whether they expect to be in a higher or lower tax bracket once they reach retirement age.
You can start an IRA by making annual contributions, but IRA rollovers are funded from money coming out of another qualified retirement plan such as a former employer’s 401(k) plan. A rollover allows you to leave a retirement plan without incurring any tax consequences.
IRA Rollover Rules
Retirement plans generally have restrictions against taking money out before you reach age 59 1/2.
If you take money out earlier than that age, you might face ordinary income taxes and a 10% penalty on some or all of the amount you take out.
An exception that allows you to avoid tax consequences is if you roll the money into another qualified retirement plan. So, if you’re leaving one employer’s 401(k) plan, you could roll that money into a 401(k) at a new employer, or start an IRA rollover.
The key rule is that you have a limited amount of time to roll your money into a new retirement plan before facing tax consequences.
- The simplest way is to do a trustee-to-trustee transfer, in which your money goes directly from one plan to another without ever passing through your hands.
- Instead, you can take a distribution into a non-retirement account to give you time to think about what to do with it. However, if you do that you only have 60 days to deposit the money in a new retirement plan or it will be considered a distribution subject to tax consequences. Also, taxes may be withheld on a distribution that’s made directly to you, even if you intend to roll it into another retirement plan within the 60-day window.
Again, a trustee-to-trustee transfer is simplest, and in any case, you have a limited amount of time to get a direct distribution from a retirement plan reinvested into a new retirement plan. So, it’s best to line up your rollover choice before you leave a retirement plan.
Investing Your Rollover IRA
One reason it’s important to line up a rollover destination in advance is so you can choose an IRA rollover provider that has the investment options that you want.
Broadly speaking, deciding how to invest your IRA rollover often comes down to a choice between liquidity vs. growth:
- Liquidity means money that’s available for withdrawal. This involves investing in things with stable values that you can count on, and that you can access when you need them.
- Growth means investing in long-term investments that may fluctuate in value but have a chance at increasing in value over time. Growth can help your retirement assets keep up with inflation, which is especially important if you’re going to be investing for a long time.
Liquidity can help you manage your money so cash will be available when it’s time to take distributions from your retirement plan. Growth can help your money do more for you in the future.
A nice thing about an IRA rollover is that you can think of it as a type of container for investments. You can put just about any type of investment in that container.
So, there’s a place for investments ranging anywhere from liquidity to growth. The sections that follow will look at both ends of this spectrum.
IRA Rollover Investments: Cash Management for Distributions
Liquidity is most important for making money ready for distributions from your IRA. So, the closer you are to retirement age, the more your investments should lean towards liquidity.
Savings and money market accounts allow you to access your money at any time. The drawback is that they tend to have very low interest rates.
Since distributions from an IRA are somewhat predictable, CDs can be a good investment for people who are nearing the point of taking some money out of the account.
Learn how these accounts differ: Compare savings accounts, money market accounts and CDs
One advantage of CDs is that they tend to offer higher interest rates than savings and money market accounts.
Also, CDs make money available at a specified time, at the end of the CD’s term. So, you can line up a series of CDs with different maturity dates to manage when cash will become available for your planned distributions from your retirement plan.
With all bank products, interest rates vary a lot from one bank to another, so it’s important to shop around. This is especially important when it comes to CDs, because any rate advantage you find may be locked in for years to come.
Finally, there are more and more cash management options being offered these days by brokerage firms and other types of financial institutions. These are worth considering because they may offer better rates than bank products.
On the other hand, you have to be careful because often these products will not offer the safety of federal deposit insurance. They may also have fees that offset their rate advantage.
IRA cash management investments: What to look for
So, when looking for investments to meet your cash management needs in an IRA, here are some things to look for:
- Make sure you’re comfortable with the safety of the investment, such as whether or not it’s covered by federal deposit insurance.
- Line up the timing of when the investment makes cash available with the timing of your IRA distribution plans. Remember that the longer you’re willing to commit your money, the higher the interest rate you’re likely to get.
- Shop around and compare rates on CDs and other cash management products.
- Besides comparing rates, watch out for fees that may offset the interest you earn.
IRA Rollover Investments: Growth for Longer-Term Needs
Just because you’re rolling out of a retirement plan doesn’t mean you should stop investing for growth.
In particular, if you’re rolling out of a plan because you’re leaving an employer but still have many years to go before retirement, your rollover investments should be growth-oriented.
Even once you reach retirement age, keep in mind that you still have many years’ worth of retirement spending to fund with your investments. It may make sense to have at least some of them in growth investments to help you keep up with inflation.
For growth investments, you can have your IRA in a brokerage account so you can buy individual securities or mutual funds yourself. If you’d rather not make those decisions yourself you can have your IRA professionally managed by a financial advisor or used an automated robo-advisor approach.
IRA growth investments: What to look for
When choosing growth investments for your IRA rollover, here are some things to consider:
- Match the risk level with your needs and comfort level.
- Look into the regulatory background of any provider you choose.
- Expenses are crucial because they can eat away at the returns you earn. Make sure you understand the amount of all fees and commissions involved, and what incentives they create for the firm that’s handling your money.
- When choosing an investment firm, remember that past track records are often deceiving. Competence and reputation may be more important.
In summary, IRA rollovers can perform two tasks for you. They can help you avoid immediate tax consequences when you leave an employer’s retirement plan. Plus, they can allow you to continue to invest according to your needs.
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