To rollover or not rollover, that is the question.

I want to cover a topic that has the potential to affect the majority of workers here in the U.S. today.  What should you do with an old 401k?  Should you roll it over, should you do something else, what should you do?  Well, first things first, I want to cover the four basic options you have for your employer-sponsored retirement plan (401k, 403b, 457b being the main ones) when you separate from service from your employer.

The first option a worker with an employer-sponsored retirement account has when he/she leaves the company is to simply cash-out the account.  This means you take the money in the account as a lump-sum distribution.  This is almost always the least desirable choice one can make with their retirement account.  The reason being, once you take the distribution, Uncle Sam gets excited because he can now tax you on that money.  All of your distribution will count as ordinary income in the year in which you receive the distribution.  This means whatever the amount of your distribution, it will automatically be added to your income from employment or any other sources of income you may have, and you will owe tax on that entire income amount (yes, this could potentially place you in a higher tax bracket as a result).  If you are under 59 1/2 (there is one exception to this for those age 55 and older, but you need to research that out yourself, I am not a tax advisor) you will pay an additional 10% early withdrawal penalty to the IRS in addition to the previously mentioned overall income tax.  This is why I say cashing the retirement account out when you leave employment is not usually the option you should pursue.

The second option is you may be able to leave the money where it currently is with your former employer.  You will need to check with your employer, but most companies now will allow you to keep your retirement assets in their plan provided they are at least a minimum amount (usually at least $1000 – $5,000).  The third option is you can roll your previous retirement account over to your new employer, assuming they offer a retirement plan and assuming that plan allows rollovers (most do accept rollovers but for certain types of accounts there may be a restriction).  The last option is you can possibly roll the funds over to a Rollover IRA.  In the last three options that I mentioned, you will not be assessed any taxes on the transaction because you were keeping the plan where it was, or you were rolling the funds over in order to preserve the pre-tax and tax-deferred status of the account.

Now the question-what should you do?  One thing any first semester MBA student will tell you is, if the professor asks a question, the best answer is – it depends. “It depends” is the correct answer to this question, in my opinion, and I will tell you why I believe that.  The longer I am in this business, the more I see examples of how the individual needs to do what is best for their unique situation.  Not what is best for a financial advisor or financial planner, not what was best for their Uncle Bob, not what was suggested to them in a magazine, or what they heard on a radio talk show.  No, you need to do what is best for your situation.

There is also a fair amount of misinformation out there as well.  I have met with dozens of people that believe they should roll their money over into just one account so they can get the power of compounding returns working stronger for them.  I hate to burst their bubble, but I do have to tell them, that only works if they have different investments in the respective accounts.

Here is an example.  I once met with a gentleman who wanted to roll over his former retirement account to his new employer’s plan.  That is fine, he can do that, no problem.  The problem was his reasoning.  He was invested in an S&P 500 Index fund in his old 401k plan, and his intention was to do the same in the new plan.  He told me he wanted all the assets in one place so he would make more money because of the affect of compounding returns.  I had to tell him this was not the case.  The S&P 500 fund was going to have the same return as the index minus the management fee (in this case it was literally the exact same fund, share class and all).  He argued with me for several minutes until I finally showed him the numbers.  Here was the example I showed him: if you have $1,000 in one account (since he was just starting the new job) and $100,000 in the previous company’s retirement plan, and the investment in the accounts returns 10% (remember, he had the exact same fund in both accounts, he just assumed having the money all together would magically produce a combined higher rate of return through compounding), his total return is $1,000 X 10% = $100 gain + $100,000 X 10% = $10,000 gain.  His total account value in the one account was now $1,100, and the other account now had a value of $110,000 for a new grand total of $111,100.

Notice this is the same return if the $100,000 account had been rolled into the $1,000 account producing a $101,000 single account.  The rate of return was the exact same because the investment was the exact same.  Rolling the former employer’s account over may have been the right thing for this gentleman to do, but not for the reason he gave me.  By the way, I asked him how he came up with the idea he would get a greater return on his funds even though it was in the same investment – his answer – his brother-in-law told him that was the case.  Another reason not to listen to your brother-in-law.  I can see this post is getting rather long.  I will continue this topic in my next post.  Thank you to those who have made comments, I appreciate your encouragement.


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