What should you do with your 401(k) when you change jobs? Should you move it into your new employe's 401(k) or roll it into an IRA?
Unless you want to take the tax and penalty hit, never take a check from your 401(k) made out directly to you. You must do what is called a direct transfer from trustee to trustee. The money can never see the inside of your bank account or taxable brokerage account. The check must be transferred directly into an established traditional IRA or a new employer 401(k) plan.
If your account balance is more than $5,000, you can leave it in your previous employer's 401(k). However, it is recommended that you don't leave money behind. Balances at various employers is never monitored or rebalanced. Over time, these balances can be lost, especially if your mailing address changes. It also creates a mess for your heirs who have no idea that you have multiple 401(k) balances at different companies. Your best bet is to either roll over your balance directly into your new employer's 401(k) plan or to an IRA you've established at a brokerage firm.
If you are considering rolling funds to an IRA, make sure it is a traditional IRA (not a SEP or Simple) and does not hold funds that were contributed after tax. Rolling your retirement funds into an IRA affords more flexibility than you usually have with a 401(k) plan. Many 401(k) plans offer only a few investment options, which might be poorly managed or charge high fees.
The administrative costs and the money management fees of the employer's 401(k) plan are reported to you. You see your account's performance only after the fees have been subtracted. These fees can easily constitute a two percent (2%) per year withdrawal from your account, which is significant and can compromise the long-term performance of your portfolio. If your account balance is $100,000, you could be paying fees of $2,000 a year without realizing it.
Moving your funds to an IRA solves both of these problems. In an IRA, you are able to customize a portfolio to meet your specific investment goals and risk profile. There are money brokerage firms that have huge mutual fund supermarkets and charge reasonable commission and custodial fees. Make sure your brokerage firm offers a good selection of mutual funds that are well managed and charge a reasonable fee. You can also invest in stocks and bonds directly in your IRA option that is not available in most 401(k) plans.
IRAs still offer a greater flexibility in estate planning than 401(k)s do. For instance, if you have multiple beneficiaries with substantially different ages, you may want to establish a separate one for each beneficiary. This would allow you to create different portfolios to meet the investment objectives of each beneficiary.
Although it is usually a good idea to move your 401(k) plan to an IRA, there are a few special conditions that might cause you to move the funds to your new employer's 401(k) plan instead.
You may decide to transfer your old 401(k) to your new 401(k) plan in order to have the flexibility to retire earlier. If you plan to retire from ages 55 to 59 1/2, you may want to leave retirement funds in the 401(k) plan so you can access the money without incurring the ten percent (10%) penalty. This is available only if your company's plan allows for distributions before normal retirement age (59 1/2) and you separated from service after age 55.
IRAs do offer some relief in special circumstances that are not available to funds in 401(k) plans. You can take IRA distributions before age 59 1/2 to pay for qualified higher education expenses for yourself, your spouse, your children or grandchildren, and incur no penalty. There is no dollar limit on IRA early withdrawals for qualifed higher education expenses. However, these expenses must be incurred and paid for during the same taxable year, and distribution amounts that exceed annual qualified higher education expenses are subject to the ten percent (10%) penalty tax. You'll still have to pay the regular income tax on the distribution.
Another special circumstance that allows you to avoid the ten percent (10%) penalty for early distributions from an IRA is available to first-time home buyers. You can withdraw as mush as $10,000 from your IRA toward the purchase of your first home.
