Got Old Retirement Accounts? 5 Costly Mistakes to Avoid
Having retirement accounts with previous employers can leave you unsure about what to do with them. Laura reviews your options five costly mistakes to avoid when dealing with your old retirement plans.
Laura Adams, MBA
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Got Old Retirement Accounts? 5 Costly Mistakes to Avoid
Sue B. says, “I’ve had multiple jobs in the past few years and still have a different retirement plan from each one. Should I roll them all over into an IRA for better tracking or just keep them in their separate accounts?”
Thanks for your question, Sue! The average American worker will have more than 11 jobs in their lifetimes, according to the Bureau of Labor Statistics. Chances are many will come with a retirement plan, such as a 401(k), a 403(b), or a Thrift Savings Plan (TSP), if you work for the federal government.
But knowing what to do with an old retirement plan when you change jobs can be confusing. In this post, I’ll review your options and cover five costly mistakes to avoid.
5 Costly Mistakes to Avoid With Old Retirement Accounts
- Cashing out old account balances.
- Forgetting about old plans.
- Missing the benefits of consolidation.
- Not factoring in your age.
- Doing an indirect rollover.
Before making any moves with your retirement account, make sure you understand some of the biggest missteps and how to avoid them.
1. Cashing out old account balances.
By far, the worst mistake you can make with an old retirement account is cashing it out. So I’m glad that Sue didn’t say this option was on her mind.
Many people get lured into cashing out an old retirement plan because it’s tempting and easy to do. Problem is, cashing out is incredibly expensive. If you’re younger than age 59½, taking a retirement distribution means you must pay income tax, plus an additional 10% early withdrawal penalty.
Here’s an example: Let’s say you have a balance in a traditional account of $50,000 and decide to cash out. If you must pay 40% for federal and state tax, plus an additional 10% penalty, you lose 50%. Your $50,000 retirement balance just shrunk to $25,000 in one fell swoop. That makes me want to cry!
If your distribution is large enough, it could also push you into a higher tax bracket for the year, costing you even more in taxes. In addition, you lose all future growth that your account could have earned.
For instance, if you’re 30 years away from retirement, $50,000 could grow to more than $500,000, assuming an 8% annual return. So requesting a lump sum distribution and shutting down your account could cost hundreds of thousands of dollars over the long run.
Cashing out a Roth account isn’t as harsh because you previously paid tax on your contributions. However, your earnings (but not your original contributions) in the account would still be subject to income tax and a 10% penalty.
2. Forgetting about old plans.
Another major mistake is simply forgetting to do anything with your old retirement accounts. Sue obviously hasn’t fallen prey to this blunder, either.
If your account has less than a minimum, typically $1,000, your employer has the option to cash you out. If you have more, but less than $5,000, your employer can transfer your balance to an IRA.
If your account satisfies a minimum balance then you can leave your money in a previous employer’s plan, but there are several downsides. One is that you can’t make any new contributions to the account after you’re no longer employed there. Another is that you may be charged extra maintenance fees or be prohibited from benefits that employees get, such as taking hardship distributions.
However, if you do leave a retirement account at an old job, you have the same account access. You can manage it any way you like by selling and buying funds from the available menu of investment options. It can continue to grow and you’ll still get nice tax advantages.
If a former employer’s plan has a terrific menu of diversified investments with low fees, leaving your money there may be a good idea. It’s definitely better than cashing out and you can always do a tax-free rollover in the future, which we’ll cover next.
See also: How to Invest Money in Your IRA or 401k Retirement Account
3. Missing the benefits of consolidation.
As I previously mentioned, if you have multiple jobs during your career, you could end up with a bunch of different retirement plans. Not consolidating them is usually a mistake.
Having all your funds with a single financial institution means you’ll have a larger account balance, which may qualify you for lower fees or other perks. Plus, having all your retirement savings in one place makes it easier to track. Just make sure that the new plan has a wide selection of investment choices with low fees.
If you have a new job with a retirement plan, you may be able to roll over your old plan into the new one, once you’re eligible to participate. But in some cases, incoming 401(k) or 403(b) rollovers aren’t allowed, so be sure to check the plan’s rules or ask your new benefits administrator.
Another important consideration is the legal protection that your money has while it’s in a 401(k). The Employee Retirement Income Security Act of 1974 (ERISA) doesn’t allow creditors, except the federal government, to touch funds in a qualified workplace plan. In other words, if you get into financial trouble because you can’t pay your mortgage, the lender could sue you, but wouldn’t be able to take your 401(k) money to repay your debt.
If you don’t have a job with a retirement plan, you can roll over an old retirement plan into a new or existing traditional or Roth IRA, which is an Individual Retirement Arrangement. Even though it’s different than a 401(k), doing a rollover to an IRA within 60 days doesn’t trigger income tax or a penalty.
Since traditional retirement contributions are made on a pre-tax basis and Roth contributions are after-tax, you can only roll over workplace accounts into like accounts without triggering a tax consequence. For instance, you can roll over a traditional 401k into a traditional IRA and a Roth 401k into a Roth IRA.
Moving money from a traditional workplace account into a Roth IRA would be considered a Roth conversion, making you responsible for income tax on any amounts that weren’t previously taxed. So, I generally don’t recommend doing a Roth conversion because it can result in a huge tax liability.
Also, note that doing a retirement rollover is different than making an account contribution. So, the annual income thresholds that make high-earners ineligible to contribute to a Roth IRA don’t apply for rollovers.
Doing an IRA rollover is typically the best option for old retirement accounts because it gives you the most flexibility and control, and this is what I recommend for Sue. You choose the financial institution and have the freedom to pick from a wide range of investments. You’ll have a full range of options—such as stocks, bonds, and exchange-traded funds—that are typically not included on the investment menu for a 401(k).
Additionally, unlike with a workplace retirement account, there are situations when you can take money out of an IRA, before reaching age 59½, and avoid the expensive 10% penalty. Some exceptions include using IRA funds for medical expenses, college costs, and buying or building your first home. Just remember that you’ll still have to pay ordinary income tax on those withdrawals.
The major downside to rolling over an old retirement plan into an IRA is that depending on the state where you live, IRA assets may not be protected from creditors through ERISA, the law that I previously mentioned.
Whether creditors can touch some or all of your retirement money in an IRA varies from state to state. So, if protecting your retirement from creditors is a concern for you, be sure to ask your existing or potential new IRA custodian about your state’s regulations.
See also: Retirement Account Comparison Chart (PDF download) is a handy, one-page resource to learn more about different types of retirement accounts.
4. Not factoring in your age.
If you’re 55 or older, not taking special retirement withdrawal rules into account is a mistake. If you lose or quit your job in the year you turn 55 or later, you can take withdrawals from a retirement plan at work without having to pay the additional 10% early withdrawal penalty.
But if you do a rollover into an IRA or a new workplace retirement plan, you must wait until age 59½ to avoid the early withdrawal penalty. So, if you think you may need to access retirement funds between the age of 55 to 59½, it’s better to just leave your money in the old account.
See also: 10 IRA Facts Everyone Should Know
5. Doing an indirect rollover.
If you decide to roll over an old retirement account to an IRA or a new workplace plan, there are two ways to do it. Choosing an indirect rollover, instead of a direct transfer, is definitely a mistake. Let me explain.
With an indirect rollover, you receive a check for your retirement funds made payable to you. Problem is, when you receive retirement funds in your name, there’s a mandatory 20% withholding penalty applied—even if you intend to complete a rollover. This is a safeguard for the IRS, just in case you change your mind and decide to keep the cash.
For example, if you want to roll over $10,000 from your 401(k), the custodian withholds 20% for taxes and you’d only get a check made payable to you for $8,000. If you complete the rollover within 60 days, you eventually receive a refund for the withholding when you file taxes.
But that could be many months away and you lose the ability to earn potential investment gains every day that you don’t control those funds.
Failing to meet a rollover deadline means the distribution is considered an early withdrawal (if you’re younger than age 59½) and you’ll be subject to income tax plus a 10% penalty on the full amount.
With a direct rollover, your old plan administrator simply transfers your funds directly into your new account and there are no taxes withheld. This is an easy and seamless process that allows your retirement savings not to be interrupted.
In some cases, your old retirement plan may mail you a check made payable to the new account custodian or trustee. This is still considered a direct rollover because the funds are not made payable to you.
See also: 5 Retirement Options When You’re Self-Employed
What’s the Best Place for Old Retirement Accounts?
To sum up, the best place for your old retirement account depends on the flexibility and legal protections you want, the quality of your old plan, your age, and whether you have a new retirement plan that accepts rollovers. The goal is to position your retirement money where you can keep it safe and allow it to grow using low-cost, diversified investment options.
If you’re still not sure what to do with a retirement account at a previous employer, here are some key points to consider:
- A workplace retirement plan, such as a 401(k) or 403(b), typically gives you a higher level of protection from creditors compared to an IRA.
- A traditional or Roth IRA gives you a larger selection of investment options compared to a workplace plan.
- A workplace plan usually allows penalty-free withdrawals if you leave your job for any reason at age 55 or later, but this isn’t an option with an IRA.
- You must take required minimum distributions from traditional IRAs once you reach age 70½, which isn’t required for a workplace plan until you retire.
- If you’re a high earner, you won’t be eligible to make new contributions to a Roth IRA; however, it can continue to grow on a tax-free basis.
What’s right for one person’s old retirement account may not be a wise decision for another. So be sure to evaluate all your options carefully and get advice from your retirement plan custodian, when needed. Your number one goal should be to keep your retirement savings easy to manage and growing.
To create your get-out-of-debt plan and follow proven strategies to eliminate all types of debt, enroll in Laura’s super affordable online course Get Out of Debt Fast–A Proven Plan to Stay Debt-Free Forever and get started today.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.