Today’s topic comes from Jesse F., who says:
“I’m 52 and self-employed and my wife is 51 and works for a hospital. We recently moved from New Mexico to Florida. What do you recommend I do with my 401(k) from my former employer?”
Thanks for your question, Jesse! Knowing what to do with a retirement plan from an old employer, like a 401(k), 403(b), or 457, can be confusing. But handling it wisely is essential for your financial future. This post will answer your question by reviewing the best options for an old retirement account.
What is workplace retirement plan vesting?
Before you decide to leave a job, it’s essential to understand how your vesting schedule works for company benefits like a retirement plan and stock incentives. Vesting is a tool companies use to keep their employees from leaving.
When you have a workplace retirement plan, like a 401(k), you own it, plus any vested balance contributed by your employer. Note that contributions from your paycheck are immediately 100% vested. However, most companies have a vesting schedule for their matching and any profit sharing contributions.
Being “vested” means you own some or all of the funds contributed by your employer. Leaving a company before you’re vested comes with financial consequences, such as forfeiting employer-provided stock incentives, profit-sharing, or contributions to your retirement plan.
How long a vesting period lasts varies from company to company. However, a typical vesting schedule is from three to five years.
Being fully vested means that you get to keep 100% of the benefits, and being partially vested means you get a percentage of them based on a predetermined schedule.
READ ALSO: How to maximize 401(k) matching funds
What are common vesting schedules?
There are two primary types of company vesting schedules: graded and cliff. Graded vesting is the most common and gives employees benefits gradually over several years. That allows you to own some percentage of benefits even if you leave the company after a year or two.
A typical graded vesting schedule occurs over five years as follows:
- Year 1: 20% vested
- Year 2: 40% vested
- Year 3: 60% vested
- Year 4: 80% vested
- Year 5: 100% vested
If your employer contributed $20,000 to your 401(k) as a profit-sharing bonus, you’d have to remain employed for five years to get the full amount. But if you left during the third year, you’d get to keep the prior year’s vesting of 40% or $8,000 and forfeit the remaining $12,000.
Cliff vesting happens all at once rather than gradually over time. For instance, your employer may require you to stay with the company for three years to become 100% vested. If you leave before completing three years of employment, you forfeit all benefits.
If you have questions about your company’s vesting schedule, consult your benefits department or a financial advisor who can help evaluate your benefits. If you log into your online retirement account portal, you should see your contributions, your employer’s, and your vested balance. If the vesting amount equals what your employer has put it, you’re fully vested.
Depending on your situation, it may make sense to leave a job before you’re fully vested. For instance, if you get a job offer that’s $20,000 higher and your vested benefit is $5,000, you’d come out ahead by taking the new job. Just be sure to consider your total benefits package, commute time, future opportunities, and other factors before leaping to a new company.
How should you manage a retirement plan with a former employer?
Once you’re no longer employed by a company that sponsors your retirement plan, there are five ways to manage it.
- Cash it out.
Cashing out a retirement plan after leaving a job is the easiest but worst option! So, I definitely don’t recommend it for Jesse.
If you’re younger than 59.5, emptying your retirement account is an early withdrawal, subject to a 10% penalty. Plus, you must pay income taxes on amounts not previously taxed.
For example, with a traditional retirement plan, you’d owe income taxes on the full balance you cash out (except for any non-deductible contributions). With a Roth (after-tax) account, you’d owe income taxes solely on the growth portion, but not on your original contributions.
Let’s say your traditional 401(k) vested balance is $200,000, and your average tax rate is 25%. After you account for the additional 10% early withdrawal penalty, you’d lose 35% of your retirement funds, leaving you with $130,000. That’s a huge tax hit that most people wouldn’t want to pay.
- Leave it with your former employer.
Most retirement plans allow you to keep money in the account after you’re no longer employed. While it’s not the worst money move, you have less flexibility than with other options I’ll cover.
The main pro for leaving retirement money in an ex-employer’s plan is that it stays invested and grows. The downside is that you can’t make new contributions because the plan’s sponsor no longer employs you. However, you can still manage your balance, such as buying or selling investments in the account.
In addition, you can alway open up and contribute to other types of retirement accounts you qualify for, such as an IRA or self-employed plan.
I only recommend keeping money in an old employer’s retirement plan if it’s a stable company and the account charges relatively low fees. Just be certain the plan won’t charge you higher fees after you’re no longer an active employee.
Laura answers a listener’s question about using multiple Roth accounts and the annual contribution limits that apply. Listen in the player below:
- Do an IRA rollover.
A rollover is transferring some or all of your balance in a retirement account to another eligible retirement account. However, to avoid taxes and penalties, the accounts must be tax-compatible, such as transferring a traditional 401(k) to a traditional IRA or a Roth 403(b) to a Roth IRA.
In other words, you can’t roll over a pre-tax traditional 401(k) to an after-tax Roth IRA without paying taxes on the total amount.
The primary benefit of an IRA rollover is having more control over your chosen investments and financial institution. You also have the flexibility to take IRA withdrawals before age 59.5 with an IRA than a workplace account.
The critical IRA rollover rule you must follow is to complete it within 60 days. If you miss the deadline and are younger than 59.5, the transaction would be an early withdrawal, subject to income tax, plus an additional 10% penalty. However, completing a rollover to a tax-compatible account within 60 days means you pay no taxes or penalties.
If you need to open a new traditional or Roth IRA, checkout an online investing platform like Betterment or Empower. They can even do a direct rollover where funds get automatically transferred into your new account without you having to handle them.
Doing an IRA rollover is generally the best option for an old retirement plan when executed correctly!
READ ALSO: Is it better to have a traditional or Roth IRA?
- Rollover your retirement funds to a workplace plan.
Most 401(k)s and 403(b)s allow a rollover from a former employer’s plan. So, check with your benefits administrator about what’s possible. And just like an IRA rollover, you must complete a workplace plan transfer within 60 days to avoid income tax and a penalty.
Doing a workplace-to-workplace rollover may be a good option when you want to consolidate retirement funds in one account. It could make managing and tracking your investments easier.
Another benefit of having funds in an employer-sponsored retirement plan is that you can take penalty-free withdrawals as soon as 55, if you want to retire early. That’s not an option with an IRA because you must wait until 59.5.
Additionally, some workplace plans allow you to borrow money from yourself and repay it with interest over five years, which isn’t permitted with an IRA.
Laura reviews ten critical investing rules to build wealth and achieve your financial goals. Listen in the player below:
- Rollover your retirement funds to a self-employed plan.
Jesse mentioned being self-employed, giving him more retirement options to consider. If you have income from a part- or full-time business, you can move funds into a tax-compatible retirement plan for the self-employed. For instance, you could transfer funds from a traditional 401(k) to a traditional solo 401(k) or SEP-IRA.
Or, you can transfer your old 401(k) to a rollover IRA and contribute up to the annual limit to a self-employed retirement plan. There’s no limit to the number of retirement accounts you can own.
Your self-employed retirement account options depend on whether you have employees or plan to have them in your business. Some investing platforms that offer small business plans are Betterment and Empower.
To sum up, the best place to relocate retirement funds with an old employer depends on the quality of your old plan and the flexibility you want. Most retirement account owners choose an IRA rollover because it gives them more control over their funds.
If you leave another job in the future with a workplace retirement plan, you can do a rollover to the same IRA. Your goal should be to keep your retirement money where it can grow using low-cost, diversified investment options.
Contact your old retirement plan’s custodian if you have questions about transferring your funds. They can walk you through the process, ensure you follow the rules, and help you avoid paying taxes and penalties on your retirement funds.
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