Smart401k Blog

The average Generation X or Y employee will work seven jobs over the course of their lifetime.  For most of these jobs some type of a retirement plan such as a 401(k) plan will be involved.  Intrigued by this fact, I decided to do a little more research to see what these investors have been doing with their retirement plan balance when they leave their employer.

What I found shocked me.  Hewitt Associates recently published a study that revealed that 60% of employees in their 20’s are cashing out their retirement plan when they leave their job (the rate for all employees is approximately 43%) .  While I can certainly understand that times are tough, this type of behavior is very harmful to your retirement savings.  For instance, someone that cashes out a balance as small as $5000 could be passing up almost $75,000 in retirement savings (assuming the money stays invested over 35 years and compounds at an average rate of return of 8%).

I believe this behavior is caused in part by a lack of knowledge on what your options are when you leave an employer. For this installment of Common 401(k) Pitfalls, I thought I would take the time to go over those options and the pros and cons of each.

Have Your Money Paid Directly to You

As the previously mentioned study showed, this is a common choice.  If you need absolutely must have the funds this can be an option, but be aware that any amount that you have paid directly to you will be considered taxable income and if you are under the age of 59 ½, you will be assessed a 10% early withdrawal penalty.  If you do not need the funds at this time, then you may want to consider leaving the money invested using one or more of the next three options.  Especially since as I noted above, a balance as small as $5000 can growth to almost $75,000 over a 35 year period.

Leave Your Money in the Plan

Depending on your plan rules and your account balance, you may be allowed to leave the money in the plan.  If your plan has a good selection of funds this can be a good choice.  Your money will remain invested and continue to grow tax-deferred.  Leaving your money in the existing plan could also allow you to continue to take advantage of the lower costs some plans incur via things such as institutionally priced mutual funds.  On the other hand if you have subpar investment options then the above advantages will not be as beneficial.  In addition, it can be very time consuming to manage multiple retirement plans.

Roll Your Money over into an IRA

An IRA gives you greater withdrawal flexibility as well as a wider selection of investment options than a company sponsored retirement plan.  You receive greater withdrawal flexibility since an IRA allows you to choose the tax rate that is withheld up front on any distribution that you have paid directly to you.  You also get to choose which investments are sold to fund the withdrawal.  Compare this to a company sponsored retirement plan where 20% is withheld up front on any distribution paid directly to you and the distribution is funded pro-rata from all investments.

Should something happen to you and you bequeath your IRA, your beneficiaries are only required to withdraw the requirement minimum distribution for that year, thus allowing the remaining funds to grow tax free.  If beneficiaries inherit a 401(k) or similar account they are usually required to take the amount as a lump sum soon after inheriting the account.  However, they will have the option to roll over to an inherited IRA if they wish to keep the funds tax-deferred.

An IRA gives you greater investment flexibility since you will no longer be limited to the twenty or so funds that your company has chosen for you, but instead will have almost unlimited investment options.  Your only limitation will be the funds made available by the investment provider that you choose.

While an IRA does have all of the above advantages, it may also have higher fees than your company sponsored plan. IRA or brokerage providers can charge transaction fees for certain investments, inactivity or maintenance fees or miscellaneous fees such as a fee for the delivery of paper statements.

Roll Your Money over into Your New Employer’s Plan

If your new company sponsored plan accepts rollover contributions you can roll the money over into your new plan.  This will allow you to take advantage of previously mentioned institutional pricing and transaction fee transfers.  You will have fewer accounts to worry about managing. On the other hand, depending on the new plan’s rules you may not be able to withdraw any of the rollover funds should you need to access them.

You can also do any combination of the above

This option will allow you to have some money paid directly to you with the remaining portion being rolled over.  If you need to access funds but want to keep a portion of your account tax-deferred this may be the best option for you.  Please note however that you will incur the previously mentioned taxes for any money that you have paid directly to you.

Have a loan outstanding on your account?  One thing that may complicate your decision is if you have an outstanding loan.  If you have an outstanding loan, you can either pay the loan off before taking a distribution or rolling over, or you can let the loan go into default and claim the loan balance as taxable income on next year’s taxes.  If you would like additional information regarding your options with a loan go here to read our insight articles on the topic.

If you need help with your decision, please feel free to contact us or another trained advisor.  Until then, keep an eye out for the next installment of Common 401(k) pitfalls.

Buck Wendel, Investment Advisor

This entry was posted on Wednesday, November 11th, 2009 at 7:37 pm and is filed under Adviser Commentary. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.