Embracing Opportunity After a Job Transition: How to Repurpose Your 401(k)
But what should you do with your 401(k) when you leave a company? Essentially, you have four options:
- Leave the funds in your former employer’s plan;
- Roll over the funds to your new employer’s plan, if the plan accepts transfers;
- Roll over the money into an individual retirement account (IRA); or
- Withdraw the cash value of your account.
Some may jump at the chance to withdraw the cash value of their 401(k), but keep in mind that withdrawals made before age 55 are subject to a 10% penalty fee, as well as income taxes. Not to mention, you’ll be missing out on long-term potential returns that could bolster your future retirement income. However, in times of hardship, some opt to withdraw from their 401(k)s in the form of a loan, which we address below.
That said, it doesn’t matter if you are laid off, move on to another job or choose to retire; as soon as you are no longer on an employer’s payroll, you can no longer make contributions to your 401(k) with that company, nor do you continue to receive an employer match and/or profit-sharing contributions. In addition, even if you were to let the existing funds sit and continue growing (one of the four options), your portfolio remains limited to the employer’s selection of investment options. For example, if Apple stock (hypothetically) suddenly goes on sale, you may not be able to use your 401(k) savings to take advantage of the value because it is not an investment option within your employer’s 401(k) plan.
What if I’ve been furloughed?
Furloughed employees face a unique situation in terms of their ability to roll over or withdraw from their 401(k)s. For furloughed employees that receive company benefits, it is likely you are still on the payroll, consequently disqualifying the 401(k) rollover option for as long as you remain technically employed. Some company 401(k) plans, however, may allow for an in-service rollover for employees over 59 ½ years old. Stay tuned for more insights into the in-service rollover plan in an upcoming CWM blog post.
But once you and your 401(k) are no longer tied to your former employer, consider rolling over those funds into an IRA. Taking this route will enable you to regain control over your portfolio to capitalize on opportunities and access infinitely more investment choices. Below, we’ve answered some common questions and outlined the 401(k) rollover process.
What tax benefits will I gain with a 401(k) rollover?
Qualified plans (including a 401(k) plan) are regulated by ERISA (the Employee Retirement Income Security Act of 1974) and require a minimum 20% tax withholding for retirees taking withdrawals. In contrast, IRAs fall under the IRS’ purview and allow retirees to select their withholding amounts.
Beyond that key distinction, the tax treatment is, for the most part, the same for both IRAs and 401(k)s: the participant contributes pre-tax dollars that grow tax deferred. The only real difference is that a 401(k) allows you to take withdrawals as early as age 55 without the 10% premature distribution penalty (if certain conditions are met), whereas with an IRA the minimum age is 59 ½. Alternately, Roth 401(k)s and Roth IRAs are funded with after-tax dollars and grow tax-free.
Since an IRA enables you full control of your tax withholding — combined with far more investment choices — it may offer clear advantages for certain folks when compared to a 401(k).
What should I do if I have multiple 401(k)s from previous jobs?
With 75% of young professionals in favor of job-hopping, not to mention the recent uptick in layoffs as a result of the COVID-19 crisis, you may find yourself “collecting” 401(k) plans as you move from job to job. Out of sight, out of mind, right?
Not quite. By not rolling those funds over to one IRA, you may be missing out on critical opportunities to invest in your future. And the sooner you tie up the loose ends, the better. The longer you wait, the more difficult it may be to get in touch with the administrator of your previous 401(k) account, due to company turnover and other unexpected organizational changes. By establishing an IRA to serve as the primary destination for “leftover” 401(k) plans, you’ll benefit from the peace of mind that comes with knowing where those funds live — and that they’re more closely aligned with your overall strategic plan.
Keep in mind that regardless of how much time has passed since you were employed by a given company, and even if you returned to work at that same company later on, you are still eligible to transfer your 401(k) funds from your previous period of employment into an IRA.
What if I have a 401(k) loan?
One scenario in which we recommend not transferring your 401(k) funds to an IRA is if you have an outstanding loan from your 401(k). This is because the balance of the loan will be realized as a withdrawal, rather than a rollover. If you are under 59 ½ years old (or 55 if certain conditions are met), a 10% penalty is applied to that withdrawal, on top of the income taxes for which you’ll be liable.
In general, we rarely recommend 401(k) loans for CWM clients due to the significant impact to portfolio growth, combined with the repayment interest rates — which almost always increase over time.
Let’s take a client, Sally, for an example. She needs to take out a loan to afford a divorce settlement. She can borrow 50% of the value of her 401(k), or $50,000, whichever is less, but she must repay it within five years. (Note: The $50,000 limit has been extended up to $100,000 in 2020 due to the COVID-19 pandemic.)
The downside is that the interest rate for a 401(k) loan is equivalent to the borrower’s income tax bracket at the time of repayment. Chances are, over the course of five years, Sally’s income tax bracket will increase, and so will her interest payments.
We call this a loan of last resort due to the hidden true cost of the loan — not to mention the hit to your portfolio, and therefore your retirement, when you borrow from your future to pay for the present.
401(k) Rollover Process
If you’re considering a 401(k) rollover to an IRA, your CWM team can help you navigate the process in four easy steps:
- Step 1: Consult with a financial advisor to determine if this option is advantageous to you, as it’s not a one-size-fits-all solution.
- Step 2: Coordinate with your financial planning team to open a traditional and/or Roth IRA.
- Step 3: Once the new account is set up and you have the account number, contact your previous employer or 401(k) administrator to request and complete a 401(k) rollover form (Note: Some custodians allow you to give the instruction directly over the phone or online).
- Step 4: Work with the 401(k) custodian and your financial advisor to transfer the funds into your IRA.
It’s important to remember that you — the former employee — will always need to initiate the rollover, as 401(k) administrators cannot take instruction from anyone besides the employee or the employer on the plan. However, the CWM team is available to provide guidance and support — for example, your financial advisor can stay on the line with you when you call the account custodian and answer any questions that arise.
Second, if your 401(k) custodian handles the rollover process by issuing a check for you (or your financial advisor) to deposit into your IRA, it’s imperative that they make the check payable to the new IRA custodian (such as Charles Schwab, for example) “for the benefit of” the individual. If made payable to you as an individual, the funds will be treated as a withdrawal, and therefore income taxable.
Some 401(k) custodians have transitioned to a much more streamlined process in which they forego the paper check, and transfer your funds directly into a new IRA via phone authorization. The logistics simply depend on each custodian’s practices.
CWM is here to help you navigate your path toward your lifestyle goals, at any age and stage of your journey. If you or someone you know is interested in talking through the 401(k) rollover option, or have other questions about retirement planning, please contact us online or at 425.778.6160 to schedule a free, no-obligation phone call.
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