The 401(k) system has a lot of shortcomings. It emerged as a more cost effective alternative to defined benefit plans like pensions during the mid 1980s. Pensions pay out pre-determined amount, sometimes for life, which was expensive for companies, so a new system was devised under a doctrine of personal responsibility. Instead of “work this long, and get this much money for this long,” it became a lot more of “whatever you put in, we’ll put in a corresponding amount too.”
This is a bit reductive, but if we’re going to sum up ~35 years of history in asset management and retirement planning in a paragraph, it’ll do.
This shift put a lot more pressure on savers. You have to remember to enroll in a retirement plan in the first place, flip through a confusing investment prospectus, and figure out how much of your paycheck you can forgo; to say nothing of ethical concerns like making sure you haven’t invested in arms manufacturers or prison operators or any other investment that leaves you feeling conflicted ethically.
Fortunately, some things are getting better. Largely thanks to the efforts of behavioral economists like Richard Thaler (who won last year’s Nobel Memorial Prize in Economics), employers are automatically enrolling their workers in retirement plans in record numbers. The thinking is that doing money stuff — whether it’s constructive or not — still kind of sucks. If you can make not saving the chore instead of saving, lots of people with be thanking you in about 40 years or so.
The downside of being enrolled into plans automatically, particularly if you’re a bit of a job hopper, is that it becomes increasingly important to remember to make sure those funds follow you from job to job. It’s your money, after all, so let’s run through the pros and cons of the four things to do with an old 401(k), with Doug Boneparth, a certified financial planner with a reputation for working with younger investors.
4. Don’t Do Anything
I didn’t fully understand this until I chatted with Doug, but you can actually just leave your 401(k) where it is and do nothing.
“No one is forcing you out of the plan, unless your balance is under $5K,” Boneparth explained (he hedged the $5K number but I looked it up and it checks out). “It may either be automatically rolled over, or they’ll just cut you a check.”
The pros to this method are fairly intuitive, doing nothing is very, very easy. But the cons are that you may be leaving money on the table by not taking your destiny into your own hands a little bit more. Small 401(k) balances usually get rolled over into an individual retirement account of the provider’s choosing. The IRA they pick for you could be just fine, or it could be terrible. That’s why nothing is very unlikely to be your best option here, so let’s move on.
3. Roll it over to your new job’s plan
If you have a good retirement plan through work, this is probably a no-brainer. Matching funds for your 401(k) is money in the bank, after all, even if you can’t touch it for a few decades. But this isn’t always the best play, Boneparth explained.
“The drawback is you’re limited to the choices in the new plan, which is a good thing if they’re better choices,” he said. “Most of the time the costs in a 401(k) are borne by the company, but that’s not always true, a lot of those costs can be passed along to the plan participants. And unfortunately, it’s not the most transparent thing in the world, expenses can be baked into the particular investments in the plan.”
If the retirement plan options at your employer aren’t great, you may see greater benefit taking things into your own hands, which brings us to option 2.
2. Roll it over into an IRA
It’s important to invest because it puts your money to work and keeps your from wealth from being degraded by inflation. It’s important to use retirement vehicles like 401(k)s to make those investments because they have tax benefits, Boneparth explained.
“Tax savings, is what makes these so powerful,” he explained, adding, “you can’t really replicate that outside of the retirement plan.”
Tax-wise, the 401(k)’s nearest relative is the traditional IRA, an individual retirement account where the money is taxed when you withdraw it as opposed to when it goes in. Because they have the same tax structure, you can roll a 401(k) into an IRA without paying any fees or penalties. You can roll a 401(k) over into an IRA pretty easily by calling up a broker (Vanguard is famous for its low fees, and Fidelity just introduced zero fee index funds) who can transfer the funds for you once you enroll.
The advantage here is personalization. You can have a robot manage your IRA, toss it into the general market, or have a pro like Doug take it over and manage it for you. If you’re looking at a 401(k) at work, and notice any red flags — an expense ratio over 1 percent or so, a provider that’s taken some heat in the news — then it’s probably the move.
1. Take the money and run.
Of course, it is your money, and you can always call your old employer’s 401(k) plan up and tell them to cut you a check. But this is only something you should consider if you really, really, need the money, Boneparth explained, because you pay a 10 percent penalty for withdrawing the cash early.
This might not be the end of the world financially, particularly if the balance is tiny. But remember, momentum is an important factor to consider too. I realize it’s a lot to ask, but by now you’ve made it to the end of the first week after Labor Day. You get momentum. And you’ve got this.