Legacy 401(k) Plans

As tax season winds down and you start digging yourself out from underneath piles of tax documents and financial statements, this makes an ideal time to simplify your finances by consolidating accounts.  A great place to start would be with your former employer-sponsored retirement plans.  If you participated in a workplace retirement plan such as a 401(k) and changed jobs or retired, you have several options for that plan.  You can cash it out, leave it alone, transfer it to your current employer’s plan or roll it over to an IRA.  For many, making this decision can be a source of confusion and fear.  It is for these reasons, many choose to forgo action, and miss out on opportunities.

In most circumstances, cashing out of your retirement plan is the least favorable of the four options.  This is especially true if you are under the age 59 1/2, because you will pay a 10% early withdrawal penalty, in addition to income tax, on the distribution.  Also, by cashing out the plan you will lose all future tax deferred growth which could prove costly over the long term.

The most popular option is to roll over the 401(k) assets into an IRA.  Other alternatives include leaving all the assets in the current plan or transferring them to your new employer’s plan.  If you choose to leave it alone, there is not much to do besides monitoring the current investments.

However, before you pull the trigger on rolling over your legacy 401(k) to an IRA, there are several pros and cons that you need to take into consideration.  First, the top reason for rolling over a 401(k) to an IRA is that you would gain more investment options and have more control over the account.  Typically, 401(k) plan investment options are determined by the employer and the plan custodian.  Unfortunately, many of these investment options are limited to mutual funds with high fees and high expense ratios, or insurance products.  So, if you’re an investor who wants a larger universe of investment choices—such as individual stocks, bonds, or real estate—that’s easy to do in an IRA.

Along with limited investment choices, 401(k) plans also have many restrictions.  For example, some plans limit the number of times per year participants can rebalance their portfolios, while others restrict their participant’s rebalancing activity to certain times of the year.  In addition, some plans don’t allow the participant to choose the investment for the employer contribution portion of the 401(k) account, even after they are no longer an employee.

Also, keep in mind that if you change jobs and you leave your 401(k) account with your former employer’s plan, characteristics of the plan can change at any time.  If you don’t work there, you might not get the latest information as quickly as those who do.  When these big changes are scheduled to occur, the employer usually holds information sessions to communicate the changes.  If you don’t work there, these in-person sessions may not be available to you.  If you don’t pay close attention to your 401(k) statements, you might not even know about the changes until after they occur.

Another negative about the 401(k) plans is that they can carry high administrative fees which will cut into your investment returns over the years.  If you roll your money over to an IRA, you may be able to avoid paying administrative costs.  Also, some 401(k) plans will charge an extra maintenance fee once you are no longer an employee.  Check with your former employer to determine if this fee applies to your plan.

If you are one who frequently changes jobs and have several different 401(k) accounts, you might consider consolidating them into an IRA.  It’s much easier to check on your investments if they are all in one IRA instead of many 401(k)s.  A single IRA also makes it much easier to revamp your investments.  You will be surprised at how much in fees you are paying as your 401(k) balance grows.

There are some positive reasons for keeping your 401(k) plan in its current state.  The first is that it offers limited creditor protection.  401(k)s are protected against lawsuits, and in bankruptcy against claims from creditors.  IRA protection from creditors varies by state, and bankruptcy protection is limited to about $1.36 million, with adjustments for inflation made every three years.  The next adjustment is in 2022.

Another case for a 401(k) is if you are separating from your employer at age 55 or older, known as the Rule of 55.  If you leave or are fired from the company sponsoring your 401(k) plan at age 55 or older, you're allowed to cash out that account in the form of a lump sum withdrawal without incurring penalties.  You can't, however, leave that same job at 54, wait a year, and then start taking those withdrawals penalty-free—the rule doesn't work like that.

Finally, both 401(k)s and traditional IRAs have required minimum distributions beginning at age 72.  However, 401(k)s have a loophole.  As long as the plan allows it, participants are allowed to delay the required distributions until they retire, even if they do so after 72.

If you find yourself in this circumstance, please give Provident Investment Management a call.  We help you evaluate all the options and run the numbers in order to determine which option is best suited for you.

Dan Krstevski, CFP®