What Should You Do With Your 401k When You Retire?
***Video Transcript***
Do you have a significant 401k balance with your employer? Are you unsure what to do with it after you retire? Then stay tuned because, in this video, I'm going to discuss three things you can do with your 401k when you retire. And stay tuned until the very end, when I give you six questions to help you analyze the best option for you.
Hi. My name is JP Geisbauer, Founder of Centerpoint Financial Management. I'm a certified public accountant and a certified financial planner professional, and this channel is dedicated to helping diligent savers maximize their lives and minimize their taxes as they transition into retirement.
The use of 401ks has exploded since their inception in the early nineteen eighties. According to the Investment Company Institute, there were 7.4 trillion dollars of assets in 401k plans at the end of 2023.
And why wouldn't they? 401k plans provide great benefits to Americans, particularly high-wage earners. They are easy to elect into and to contribute to for employees and for employers that may want to match or provide a profit-sharing benefit…once the funds in the account are invested, they are able to grow tax-deferred until you decide to take your money out, meaning your account can grow tax-free for decades.
The biggest downside to a 401k is that you can't take distributions until age 59.5 without incurring a 10% early withdrawal penalty. But as long as you are aware of this and are earmarking these funds for your retirement, this early withdrawal penalty shouldn't be an issue. Suffice it to say, it's no wonder why so many savers have such significant 401k balances.
But as you get closer to retirement, you may ask yourself, “What am I going do with this account?” In this video, I will discuss the three primary options available to you.
Option one, stay invested in your employer's plan.
Depending upon the rules of your employer's plan, you may be able to stay invested in the plan even after you retire. But why would you want to do this?
The first reason, it's easy. Maybe you don't understand investing, or maybe you don't trust investment advisors. Maybe the plan has done very well for you, and your assets have grown. If that's the case, then staying put might be the right option for you.
Number two, your employer's plan has great investment options. Now, what do I mean by great investment options? Well, they're primarily two characteristics. Number one, they're inexpensive, meaning that the management fees charged within the fund are low. And number two, they offer a wide variety of asset classes to you. Typically, the 401k plan will select the investment funds that you are able to invest in. So, you'll want to make sure that there's wide exposure to the segments of the market to give you the options that you need to make the right investment decisions. So, if you've got low fees and good investment options, then there may not be a reason to leave.
Number three, your employer’s 401k plan may offer legal protections. Because an employer's 401k plan is covered by ERISA, there may be some legal protections associated with that account. Now I'm not an attorney, but if this is something that interests you, then you may want to consult one to make sure you indeed are protected.
Number four, your employer's 401k plan may offer the rule of fifty-five option. You'll have to do a bit of research to see if this rule applies to you, but there is a way to begin taking distributions from your employer's 401k plan at age fifty-five without having to incur the 10% early withdrawal penalty. It primarily relates to people that are either retiring early or getting laid off. Now, these rules can be tricky. And, if done incorrectly, you will be subject to both income tax on the distributions and the early 10% early withdrawal penalty. So, if you do decide to use this option, please consult with your CPA or other tax advisor to make sure that you are doing this correctly.
So now that we've discussed reasons why you may want to stay, what are some reasons why you may want to leave? The first one may be a little bit more emotional than analytical. The reason to leave might just be that that chapter of your life is closed and you really don't want to have any more connection with your former employer, for whatever reason. So, if opening up a statement and seeing your former employer's logo gets you thinking about the old job and maybe some situations that you didn't particularly care for, then it may make sense to move.
Number two, you have no interest in staying up to date with any changes to the 401k plan. Let's face it, employers can change aspects of 401k plans whenever they want. Now, they typically don't. And, once the plan is established, chances are they won't make many changes to it. But if your employer decides to change the investment line-up, or any other aspect of the plan, you'll have to keep up with them. And you might just decide that you don't want to do that. In that case, it makes sense to leave your 401k plan.
Number three, high fees and fewer investment options. If your employer's 401k plan is just not good and only has high fees and very few investment options, then it might be time to make a change. What do I mean by high fees? There can be a range. I've seen great employer plans that have investment funds as low as you know two or three basis points. That's basically two percent of one percent. That's how low they are! I have also seen funds with fees in excess of 1.5%. So, there can be a wide range of fees as it relates to investment options in 401k plans. Make sure you do research to see what those fees are for your particular investments. And if they're very high, it might be a good time to move your asset.
Number four, proportional distribution. Your employer's four zero one plan may require that you take distributions proportionally across all of your investment funds. So let me give you an example. Say you have $10,000 in your 401k account, and it's evenly invested 25% percent across four separate funds. If you were to draw down $1,000, you would need to take $250 from each one of those funds.
Now there might be an opportunity for you to do some rebalancing here. There might have been one fund that has outperformed the rest and now has a significant balance. That might be a great fund to take all of your distribution from so that your portfolio comes back into balance. But if your employer's 401k plan requires that you take proportional distributions, that might not be an option. So, make sure you do your research to see whether or not proportional distributions are required. And if they are, this might be a good enough reason to move the assets.
Number five, you want more control and flexibility. Let's face it: 401k plans are fairly rigid. You typically have somewhere between 20 and 30 fund options to choose from. They are selected by your employer or your employer's plan administrator, and you basically have to go with whatever is in there. There might be also restrictions around distributions and things like that. So, if you really want to have more freedom and the ability to do what you want to do and when you want to do it without having to comply with your 401k plan’s rules, then you may want to look at other options.
Option two, rolling over your 401k into an individual retirement account also known as an IRA. Now when you roll your funds over from your 401k account into an IRA, the transaction will be tax-free. Your 401k plan will sell all of the assets within that account, which is also tax free, and then transfer the cash to your individual retirement account. At that point in time, you'll need to be able to make the investment decisions and decide which assets to purchase so that your investments can grow. Now, you still can't take the funds out until age 59.5 without incurring the ten percent penalty. But if these funds were earmarked for your retirement, that really shouldn't be an issue. And the assets will grow tax deferred until you decide to start taking distributions.
So, what are the pros associated with moving to an individual retirement account?
First and foremost, flexibility. Once you have moved the funds into the IRA, you will have an entire universe of investments from which to choose, from individual stocks, mutual funds, ETFs, and individual bonds. So, if wanting to have all that optionality is very important to you, then moving to an IRA definitely makes sense.
Number two, it's easier to consolidate multiple retirement accounts in an IRA. If you have several 401k plans at previous employers, then you may want to consolidate all those into one IRA. This will make administration of your investment assets easier. You'll have one login to check your balance and see whether or not your asset allocation is correct. This becomes particularly important when you start becoming required take minimum distributions, or RMDs. So again, if you have multiple 401k accounts with several previous employers, consolidating them all into one IRA will just make the process that much easier.
Number three, tailored advice specifically for you. Let's face it: 401k plans are fairly cookie cutter. You'll have twenty or thirty investment options to choose from, and probably not a lot of guidance to help you decide which is the best asset allocation for you. If you roll all over your assets into an individual retirement account, you can then hire a financial advisor to help you to decide what is the best portfolio asset allocation for you given your age, risk tolerance, cash-flow needs, etc. So, if you definitely want to have someone help you manage your investment assets, moving them to an IRA will provide that flexibility.
Number four, Roth conversions. Having the flexibility to be able to do Roth conversions whenever you'd like can be tremendously valuable as you contemplate your retirement plan. Sometimes, however, in 401k plans you don't necessarily have full-flexibility to do these conversions. By moving over your assets into an individual retirement account or IRA, you'll be able to do Roth conversions whenever you feel it's necessary, or whenever it makes sense to. Now make sure you consult with your financial planner or tax adviser because Roth conversions are a taxable event. But if done correctly and efficiently, they can help save taxes throughout your life.
Number five, being able to do qualified charitable distributions. If you are charitably inclined, then doing a qualified charitable distribution in lieu of RMD may be a great option. This is particularly useful for those people that no longer itemize and no longer get a charitable deduction against their income taxes for the amounts that they give to charity. Now, there are some rules and age restrictions around these qualified charitable distributions. But for the right person, having this option by having your retirement assets in an IRA can be a huge benefit.
So those are the positives of moving your 401k to an IRA. What about the negatives?
Well, the biggest negative is that you need to be proactive in this situation. You will now need to manage these assets yourself. So, you can either choose your own investments, or hire an advisor, or just have the cash in some sort of money market vehicle earning very low interest. Just be prepared that if you do take this option, you will need to be proactive and you will need to take ownership of the process.
Option three, cashing out your 401k plan.
If you have a relatively low 401k account balance, this might be the easiest thing to do. You'll simply cash out your investments, take the distribution, and pay the income tax and potential 10% early withdrawal penalty on that amount. But if the amount is small, and ease is what you're after, then paying the tax may not make much of a difference to you. So, this is definitely an option for the small account holders.
Number two, you no longer want to have investment risk. Let's just say that you're no longer comfortable investing in the stock market. Or for some reason you need the cash. You can just decide to cash out of your 401k pay the related taxes and possible penalties, and do with your cash as you like.
So those are the two pros, if you will. But what is the big con of cashing out? Income Taxes!
Not only are you going have to pay taxes on the distribution itself? But if you're under 59.5, you're going to have to pay an additional 10% early withdrawal penalty. Now, if you are already in high tax bracket, which you may be as you're getting closer to retirement and you're in your higher earning years, this cash out could be incredibly expensive. So, this is only an option if you've discussed this with your financial advisor and CPA, and it's the thing that you absolutely want to do. But again, I cannot overstate just how expensive this will be. So do not take do not make this decision lightly.
So those are effectively your three options: stay in your employer's plan, roll the assets over to an individual retirement account or IRA, or simply cash out of the plan altogether.
So, what kind of questions should you ask yourself when deciding what is the right decision for you?
Here are six:
1. Is your 401k plan a “good” plan? What do I mean by a good plan? Well, there are essentially two characteristics: 1) there are a lot of investment options to choose from, and, 2) the investment options have very low management fees.
2. Do you want to control your investment decisions, or do you want your decisions made for you?
3. Do you need creditor protection?
4. When do you need access to your funds?
5. Do you want the ability to do Roth conversions and qualified charitable distributions?
6. Would you like your investments managed for you?
Once you've sat down and answered those six questions, I think you'd be able to make the decision that is right for you. And as all things related to this, make sure you consult with your financial advisor or tax professional to ensure the decision that you make is consistent with your retirement plan.
Well, that's it for today. I thank you for watching. If you enjoyed this content please hit like or subscribe. Or if you have any questions, please put them in the comments below. Thank you again, and I'll see you next time.
About the author:
JP Geisbauer is a Certified Public Accountant, a Certified Financial Planner ®, and the founder of Centerpoint Financial Management, LLC, a financial planning, investment management, and income tax planning firm located in Irvine, CA. JP Geisbauer is dedicated to helping California-based business owners and executives transition into retirement. He has been quoted in many news outlets including Forbes, Newsweek, US News & World Report, MarketWatch, YahooFinance, CNN and NerdWallet.
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Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes individual financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, consult with your own financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.