“If a 401K plan has been abandoned, it is extremely difficult for an individual participant to actually get access to his account.” Virginia Smith, Director of Employee Benefits U.S.Department of Labor
When you are working for a company, participating in its 401(k) plan with high contribution limits, tax deferred growth, upfront tax deductions, and a company match is a great way to save for retirement. But what do you do with your 401(k) when you move to your next job? Most individuals often make one of two mistakes; they cash it out, or they leave it in their former employers plan.
Mistake #1 – Cash it out
Cashing out a 401k is never a good idea. When you take money out you have to pay federal income taxes; and a 10 percent penalty if you are under the age of fifty-nine and a half. For example; A 50 year old in the 28 percent tax bracket, chooses to cash out his 401(k) worth $500,000. After paying $140,000 in taxes, and $50,000 in penalties, he is left with $310,000. Taking this cash distribution has reduced his retirement savings by 39%.
Mistake #2 – Leave it behind
At first blush, there is little reason to not leave a 401(k) plan with an old employer. Leaving money in a former employers plan is easy to do. There are no forms to fill out, and no additional investment decisions to make. You won’t be assessed any taxes or penalties, and your money can continue to grow tax deferred. There are however, two disadvantages of leaving money in a former employers plan. One is high fees. Every year thousands of people leave money sitting in their former employers plan without having any idea how much it costs them. According to a study by Deloitte Consulting, the average cost for a company 401k plan is 1.25%. An individual with $500,000 in 401k plan with a cost 1.25% would pay more than $140,000 in fees over 20 years.
The second and potentially bigger disadvantage is the risk of losing track of your 401k. If a former employer gets bought out, shuts it doors, or declares bankruptcy, the 401k plan for that company can become “orphaned”. An orphaned plan is one where the sponsor and fiduciary have abandoned the plan. The money in an orphaned plan is not actually lost; it is still there, but without a fiduciary and sponsor any longer overseeing the plan, the money cannot be distributed to its employees. The Department of Labor estimates there are at least 15,000 orphaned company plans each year. Since 2007, the number of businesses filing for bankruptcy has risen 46 percent.
The most effective way to avoid the risk of this ever happening is to roll a 401k into an IRA. Once you roll your 401k savings into an IRA, your former employers problems are no longer your problems. A rollover IRA allows you to have complete control of your retirement savings. A rollover IRA also provides additional advantages over a 401k:
Penalty Free Withdrawals
The IRS allows for penalty-free withdrawals from an IRA to pay college tuition for yourself, a spouse, children or grandchildren, or to pay health insurance premiums if you are unemployed, including COBRA premiums. You can also withdraw up to $10,000 penalty-free to put toward the purchase of a home.
More Investment choices
Rather than being limited to the number of funds within an employers plan, rolling your 401k into an IRA gives you access to more than 15,000 mutual funds to choose from.
Simpler Distribution Rules
There is one set of IRS rules governing required minimum distributions at age 701/2 for rollover IRA’s and another set of rules for 401k plans. If you have multiple IRA accounts, you can add up the value of all your IRAs and take the required distribution amount from any one of the accounts. If you have multiple 401(k) accounts, you must calculate the required distribution amount for each 401(k) separately and then withdraw the required amount from each account. The failure to take a distribution from a rollover IRA or 401k will result in a 50 percent penalty of the difference between the required minimum distribution and the amount you actually withdrew.
Peace of Mind
The odds of your 401k becoming lost or abandoned may be small, but it is a possibility. Imagine what it would be like if you couldn’t access your 401(k) savings when it comes time to retire? Rolling your 401k into an IRA will make sure that the retirement savings you need, will be there when you need it in retirement.