In previous posts, I’ve discussed in great detail the following topics related to retirement accounts - IRA’s (Individual Retirement Accounts) and 401k’s:
- Differences between 401k’s and IRA’s
- Different types of IRA’s – Roth vs. Traditional
- Ways to use money out of your IRA or 401k to finance home purchases
- Additional ways to use money from your tax sheltered accounts without withdrawal penalties.
The posts associated with these topics can be found at the links below.
However, I didn’t discuss the options that are available to you regarding your 401k funds if you are leaving your current job/company, and you have 401k savings that you would like to have access to afterwards.
Note: This post will assume that you have leaving your current company before normal retirement age (you are younger than 59 1/2 years old).
Options for 401k Funds
To begin, let’s look at the general options that are available to you for your 401k funds if you are leaving your current employer. The link below is a great resource/website from Vanguard that explains the process and available options.
1. Withdraw Money -
The first, and probably the most apparent option, is to to sell all of your current holdings, convert them to cash, and transfer them to your checking account. However, this route should only be used as a last resort because you will incur a 10% early withdrawal penalty from the IRS, as well as be fully taxed on your earnings as income.
2. Remain in Your Current Employer’s 401k Plan -
Depending on the company, it is possible that you can remain having a 401k account with your present company after you resign/are let go. You will just need to call the HR department/benefits service center that your company has to explain the situation and see if this is a possbility.
Personally, I would steer away from this option for the following reasons:
- Employer sponsored 401k plans generally have higher expenses / fees. An interesting fact that comes to us from Lipper Inc is that the average expense ratio for Vanguard Funds (Vanguard offers IRA accounts as well as taxable accounts) is 0.23%, while the industry average is 1.19% (as of December 31, 2009).
- Employer sponsored plans have far fewer options than Vanguard or Fidelity. For example, my Vanguard Roth IRA has hundreds of mutual fund options, while my current 401k account has less than 10, many of which are not even index funds (I steer away from actively managed funds).
- There are account minimums (usually $5000) that you have to meet once you leave the company.
- Future plan contributions are either restricted or not allowed.
3. Transfer to Another Employer Sponsored Plan -
If you are leaving your company and know that you are heading to another one, this option is available to you as well. However, as with Option 2, I would steer away from it as well.
Overall, IRA’s are a far superior retirement savings instrument compared to 401k’s. The only reasons I use a 401k are to 1) take advantage of company matching (free money) and 2) to have another tax-sheltered account available to which I can add funds after I have maxed out my IRA funding for the year. Since IRA’s are superior, I always want to take opportunities that present themselves to get out of 401k’s and in to IRA’s.
4. 401k Rollover to an IRA -
Lastly (and my favorite option), 401k’s can be converted, or “rolled-over,” to IRA’s. This phenomena is called a Rollover IRA.
What Exactly Is A Rollover IRA?
Rollover IRA’s are fairly easy to understand. Essentially, they are Traditional IRA’s that are funded through a different process, and therefore, have a different name. However, once they are set up, they act the same as Traditional IRA’s in that they have the following characteristics:
- Pre-tax contributions to the account
- Self directed investment operation (you can choose your own mutual funds)
- Tax-deferred growth – earnings are only taxed when withdrawn
What’s the Process for Setting Up a Rollover IRA?
At a high level, the key to successfully converting your 401k with your employer plan to a Rollover IRA is to keep in close communication with both your employer’s HR department and the investment company to which you are rolling over your account. The process can vary depending on the company you work with, but the general flow will be as shown below:
- Notify your company and the investment company where you will set up the Rollover IRA of what you want to do.
- Be prepared to give specific account information (account numbers, routing numbers, etc) to both parties in order to complete the transaction.
- You will then set up an IRA account online with the investment company (I prefer Vanguard) and elect which mutual funds you want to purchase with the 401k holdings.
- Your employer sponsored 401k account holdings will be liquidated, and the cash will be transferred directly to your Rollover IRA.
- And, you’re done! Not too bad right?
What are the Benefits and Drawbacks to a 401k to IRA Rollover?
- You have a lot of flexibility within your IRA account to invest in different mutual fund options
- You can set up the account with a company like Vanguard or Fidelity, which will have lower fees and a more numerous fund selection than your employer’s 401k plan.
- No fees to set up the Rollover IRA with Vanguard. There may be some small fees associated with transferring your 401k to Vanguard.
- No account minimums and no restrictions on future contributions.
- Drawback – For all practical purposes, if you have company stock (which I greatly discourage), you will have to sell it before converting your 401k account to a Rollover IRA. What is the reason for this? Typically, accounts with mutual fund companies like Vanguard and Fidelity work better if you use them for only mutual funds. It is possible to have a brokerage account within your Vanguard account, but the fees are generally pretty high.
Below is the Rollover IRA website from Vanguard.com. It is a great resource to get started converting your 401k funds to an IRA. I would highly recommend using them! Please let me know if you have any questions.
Keep on learning!
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