Here’s the scenario: you have been diligently saving up in a 401k plan for a while. You left your job, so they won’t let you contribute to your 401k anymore. Now what? This may be an opportunity to consolidate your savings and manage your investments better.
Let's consider some options, but please keep in mind this is not financial advice.
Do Nothing.
How happy are you with the investment options provided by your 401k? How about their customer service? Will they let you keep your old account open without additional fees? If you answered yes to all of these, you could take the easy route and do nothing! Rolling funds out of an old 401k account is a one-way street so there is no need to rush. There's no need to take action until you find a better alternative.
You’ll need to open a new retirement account if you want to contribute more money for retirement. This means your retirement savings will be spread across multiple accounts. Also, 401k accounts are subject to required minimum distributions (RMD) later in retirement. This means that past a certain age, you will be required to withdraw a percentage of your 401k and pay the appropriate taxes each year until the account is depleted.
Rollover to Your New 401k.
Assuming you have a new employer that provides a 401k or other retirement plan (like 403b, Simple IRA, or TSP to name a few), you might want to save money in the new 401k account. Rather than maintaining multiple 401k accounts, you could rollover your existing funds to the new employer’s plan.
However, look before you leap! Most employer sponsored plans will lock you in for the duration of your employment. Be sure this is the right move for you before transferring funds.
Accounts like 401k tend to have limited investment options, and they are different from one plan to the next. It would be wise to review their investment choices before rolling over to the new 401k. This includes investment objectives, fees, prospectuses, and performance. You’ll need to decide whether you’ll be better served by the funds in your new plan compared to the old ones.
Rollover to an IRA (popular)
A rollover to an IRA is the choice most people make when they want both flexibility and convenience. IRAs provide the greatest number of investment choices, including publicly traded stocks and ETFs. Some IRA custodians will let you invest directly in alternatives like real estate. IRAs are also great for consolidating retirement savings into a minimal number of accounts to manage.
Independent investment advisors, like us, can also directly manage IRAs for you, so you have no need to spend time researching and trading investments.
If IRAs are so great, then what’s the catch? The biggest catch is that contribution limits toward IRAs are much smaller than those of 401k accounts. However, you can contribute to both! The other catch is that 401k accounts are protected from judgements where IRAs are not, but we believe this to be a minor issue for most people; because insurance.
Convert to a Roth IRA
So-called qualified retirement accounts like the standard 401k and Traditional IRA are tax-deferred accounts. This means that the money you contribute does not get taxed up front. Instead, everything you withdraw in retirement, all contributions and earnings, are taxed as ordinary income.
What if you could turn a Traditional IRA, with all its benefits, and turn it into a tax-free account that also does not have any Required Minimum Distributions? What do we mean by tax-free? Neither your contributions nor your gains will be taxed upon withdrawal in retirement. This is what we call a Roth IRA.
Roth IRAs benefit especially from long-term investment strategies that have high expected returns. The longer you invest, and the more you earn, the larger the tax savings will be.
Roth IRA have several issues to consider. First, you're pre-paying, not avoiding, tax. Unlike qualified retirement accounts, your contributions come from after-tax money. This means that your tax bill will be a little higher up front.
Second, Roth IRAs have additional limits to contribution based on your income. Higher earners can contribute progressively less or not at all. There is presently no barrier or limit to converting a Traditional IRA to a Roth IRA, but this may not be true for much longer.
Finally, the Roth IRA has a set of five-year rules. Most of those details are beyond the scope of this article, but money converted from a Traditional IRA should not be withdrawn for at least five tax years.
You may face an enormous tax bill when performing a Roth conversion. It may still be worthwhile, but it is vital to prepare and get professional advice on this topic!
How we help our clients decide
All client engagements begin by taking the time to understand client goals and desired outcomes. Selecting the right choice from above cannot be done in isolation. We build a quantitative model that considers all client assets, income, expenses, tax situation, spending goals, and expected portfolio returns. The point isn’t to find which option saves our clients the most on their taxes, but rather to find the choice that maximizes their chances of achieving success.
Contact us for a no-obligation consultation, and we can figure out which choice is best for you.
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