Starting Out
Don't Leave Your 401(k) Behind
Employers will automatically roll over 401(k) accounts of $1,000 to $5,000 into an IRA when you leave your job. But you might be better off saying, "No, thanks."
By Cameron Huddleston, Contributing Editor, Kiplinger.com
March 24, 2005
Advertisement
New 401(k) rules will make it easier for job hoppers to keep more of their retirement savings. But most twenty-somethings climbing the ladder of success would still do better managing their financial futures on their own.
Most younger workers on a fast career track can be at a disadvantage when it comes to retirement savings. The problem is most employers don't let you begin contributing to a 401(k) until you've been with the company for some time. But after you become eligible and start contributing for six months to a year, a better job comes along and you have to start all over again.
Under the old 401(k) rules, if you had less than $5,000 in your account, your former employer would cut you a check, subtracting 20% for income tax withholding, unless you opened an individual retirement account and transferred your retirement savings. If you kept the cash, you would owe income taxes on the full amount, plus, more often than not, a 10% early withdrawal penalty.
But starting March 28, employers are required to roll over 401(k) balances between $1,000 and $5,000 into an IRA for you. No fuss, no muss.
Accounts with less than $1,000 still will be automatically cashed out -- and fall subject to taxes and penalties. Departing employees with accounts worth more than $5,000 will have the option of leaving their money in their former employer's 401(k) plan.
Do nothing, save money
The convenience factor alone makes this a pretty good deal.
Under the old rules you would have to shop around for an IRA provider, then tell your former employer to transfer the 401(k) assets to the new account.
Unfortunately, too many employees viewed this process as a confusing hassle, says Stacy Schaus, a consultant for human resources consulting firm Hewitt Associates.
A 2002 Hewitt Associates survey found that nearly nine out of ten employees with 401(k) balances of $5,000 or less cashed out. Employees also were more likely to take cash rather than roll over the assets into an IRA if they were in their 20s and had worked at a job fewer than two years.
"We may see more people remain invested because the path of no action is to have the money rolled over to an IRA," Schaus says. That's a good thing because people cashing out their 401(k)s as they move from employer to employer will be the number-one reason people won't have enough money in retirement, she says.
So how much would this save you? Well, if you're in the 25% tax bracket and were to quit with $5,000 in a 401(k), automatically rolling your 401(k) into an IRA rather than cashing out could save up to $1,750 in federal taxes and penalties.
But there's more to consider than the immediate tax loss. Cashing out will also cost you thousands of dollars in compounded interest.
For example, if that $5,000 were invested in an IRA earning an average 7% per year for 40 years, you'd have $75,000. If you changed jobs again at age 30 and 35 and cashed out $5,000 401(k) accounts both times rather than putting that money in an IRA, you'd lose out on $165,000 in potential retirement savings.
Roll it over yourself, and save more
"These rules are great," says Ed Slott, author of Parlay Your IRA into a Family Fortune, but "they're for people who will never read this article."
"If you changed jobs five times, you will have five different IRAs," he says. "You're better off taking control with your own IRA."
The same goes for people with accounts worth $5,000 or more who are given the chance to leave their money in their former employer's 401(k) plan.
"Why would you leave your money at your old job?" Slott says. "This is your life savings. Why leave it behind?"
By opening your own rollover IRA account, you can invest in what you want, you can roll over other 401(k) assets into that single account, and, best of all, you won't have to deal with your former employer.
Another option is to move the money into your new employer's plan. Not every company accepts 401(k) transfers, but those that do will often reduce the waiting period for rollovers, or will waive it entirely. You'll probably still have to wait to contribute new money to your new 401(k), but many employers are shortening the delay to as little as three months or less. And now it's even possible to transfer money between your 401(k) and another employer-sponsored retirement plan, such as a 403(b).
Opening an IRA
Before you can roll over an old 401(k), 457 or 403(b) plan, you must first pick an IRA provider. You have three main options when it comes to opening an IRA: a bank, a brokerage or mutual fund company. If you'd be investing less than $5,000 your best bet would be putting all your money in one or two mutual funds.
After you consider minimum investments (many mutual funds require $1,000 to get started) and expenses, $5,000 won't stretch very far. By investing in one or two funds, you'd only have one investment to track and less paperwork to deal with.
Some good all-in-one low-cost funds we like include:
- T. Rowe Price's Retirement Funds, which have an expense ratio of just 0.84% and a $10 annual fee if you have less than $5,000 invested in a fund. The Retirement Funds have asset allocations with a particular retirement date in mind. You pick the fund with the date the most closely corresponds to your retirement date (2005, 2010, 2015 and so on up to 2040). The 2040 Retirement Fund (TRRDX) is invested primarily in stocks, for example.
- Vanguard funds also have super-low fees. We recommend investing 75% of your assets in the Vanguard Total Stock Market Index fund (VTSMX), which is a broad-based stock market index with an expense ratio of just 0.19%, and 25% in Vanguard Total International fund (VGTSX), which has a 0.31% expense ratio.
Many fund companies will let you open an IRA online. Or you can call a fund company, and most will walk you through the roll over process step by step.
Once the IRA is open, tell your employer you want a "direct rollover," where the employer transfers your 401(k) funds directly to your IRA.
If you opt for an indirect rollover, the employer sends you the check, minus 20% withholding. You then have 60 days to put the check into your new retirement account. But here's the catch: You also have to reach deep into your bank account and pony up the 20% that was withheld too, or face an early withdrawal penalty.
You'll eventually get that extra 20% back when you file your taxes.