What should you do with your old 401(k)?

At Lundeen Abrams Advisors, we often hear, "What should I do with my 401(k) when I leave an employer?" You generally have four options:

1. Stay in the current plan

2. Move to a new employer's plan

3. Transfer to an IRA

4. Cash out your 401(k)

We usually advise against cashing out due to potential taxes and penalties. Instead, we’ll focus today on the first three options and provide an acronym to help you choose the best one for your situation.

Acronym for thinking it over

When deciding what to do with an old 401(k), we must POSE the question of which option is best for you, with each letter representing a different consideration.

Protections

Options

Services

Expenses

Protections

First off, 401(k) plans generally offer unlimited creditor protection because they are governed by the Employee Retirement Income Security Act. This law functions as a safety net, safeguarding participants in these plans through various mechanisms, one of which prevents company or employee creditors from accessing plan assets.

In contrast, IRAs do not have federal creditor protection, and their level of protection varies by state.

The need for creditor protection varies from person to person and depends on how likely one is to face lawsuits—certain professionals, like doctors and lawyers, are more at risk—or whether you have debt collectors pursuing you. But if creditors are a concern, 401(k)s provide the strongest legal protection.

Options:

Regarding options available in a retirement plan, withdrawal and investment options can vary, and some plans offer more benefits than others. We will break this down in three sub-parts:

Discretionary Distributions & Loans 

When it comes to 401(k) and IRA accounts, each type has specific rules regarding how you can withdraw your money. These rules can vary not only from one 401(k) plan to another but also between the two main types of IRAs: traditional and Roth. Therefore, we will focus on generalities.

Some accounts allow withdrawals through installments or partial payments, while others may only allow one-time withdrawals. It’s important to consult your account administrator to understand your options and use this information to determine what best meets your needs.

Additionally, withdrawals made from qualified retirement accounts before age 59.5 will incur taxes and a 10% early withdrawal penalty. This penalty serves as a deterrent from accessing the money unless absolutely necessary.

A shortlist of some common penalty-free withdrawal exceptions includes:

1. Most employers allowing current employees to take a loan against their 401(k), which must be repaid.

2. If you leave your employer in the year you turn 55 or afterward, you can withdraw penalty-free from that company's 401(k).

3. Both 401(k) and IRA accounts permit withdrawals of up to $5,000 for the birth or adoption of a child.

4. With IRA accounts, you can withdraw up to $10,000 without penalty to help purchase your first home.

5. Need money for higher education for yourself or your dependents? With IRAs, you can withdraw an unlimited amount; you will only pay taxes if the funds are used for educational purposes.

6. If you have significant medical expenses, you may be able to withdraw from a 401(k) or IRA and only pay taxes. However, it's advisable to consult with your accountant first.

7. Have you received a portion of a 401(k) due to a divorce? If so, this is considered a Qualified Domestic Relations Order (QDRO) 401(k), and any withdrawals made from it are penalty-free.

Required Distributions

Required Minimum Distributions (RMDs) are mandated withdrawals from qualified retirement accounts that begin at age 73. The rules vary depending on the account type.

For 401(k) plans, you must withdraw separately from each account. For instance, if you have three 401(k)s, you need three withdrawals. However, if you are still employed by the company that manages your 401(k), you can delay RMDs from that account until you leave your job.

For traditional IRAs, you can combine the RMD amounts from all your accounts and take the total from one account, as the government treats them as a single IRA.

Note that RMDs are not required from Roth IRAs or the Roth portion of 401(k) plans.

Investment Options

For self-directed investors, you likely know which investment options are important to you. Consider whether your old 401(k) plan offers sufficient or unique choices, such as stable value funds. If these options are lacking, an IRA could be a better alternative since they generally provide a broader range of investments.

For those who prefer a hands-off approach, consider whether you want your money professionally managed for a fee or if you'd like an automated investment that helps reduce risk over time. If you choose a professionally managed solution, see which accounts offer this service and select the one you're most comfortable with. Remember to ask about any associated costs, including management fees and other charges.

If you opt for an automated investment, such as a target-date retirement fund, compare the options available in your old and new 401(k) and IRA accounts, while focusing on cost and performence for each one.

Services

When considering a retirement plan, it's important to evaluate additional features that vary by provider and account type. For instance, some 401(k) plans offer financial planning services at no extra cost, while certain IRAs provide premium tiers for larger investments or holistic retirement planning. Understanding these services is crucial, so be sure to ask each provider what they offer and weigh which ones matter most to you.

Expenses

When evaluating retirement accounts, it's essential to check the fees associated with both the account and the investments. Some 401(k) plans charge account fees for administration, whereas many IRA providers do not. It's advisable to compare costs across different companies to see what you will pay at each.

Another important factor is the cost of the investments in your 401(k), specifically the expense ratio. This ratio indicates the cost of operating a mutual fund. Many 401(k) plans offer discounted expense ratios because employees buy in bulk, similar to shopping at warehouse retailers. Typically, larger companies provide lower investment costs.

In contrast, while IRA accounts often allow for more investment choices, you purchase as an individual, lacking the collective bargaining power of a company. This means you are likely to face standard (and potentially higher) expense ratios.

Conclusion

So now that you know the different factors in choosing the correct retirement account, which will you choose?

It may be tough to weigh which features mattered most during the questions you POSEd to yourself. Some people may find retirement account features trivial and prefer the simplicity of consolidating, while others face more complex decisions based on their unique situation. If you fall into the latter category, consulting a qualified tax, financial, and legal expert is beneficial.

At Lundeen Abrams Advisors, we provide holistic retirement planning and investment management services. If you are looking for an advisor or weighing what to do with your old 401(k) please call us so we can schedule a consultation to discuss your unique situation and needs. We will look forward to talking with you soon, have a great day!