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Put yourself into this hypothetical scenario. You just landed a new job in a dental practice that offers a 401K. Great. But what do you do with your old 401K? Leave it where it is, or roll it over to your new employer? Each move comes with pros and cons. There are, however, common pitfalls that you should avoid.
Should you roll over your 401K or leave it where it is? The right choice depends on several factors, described below.
I’m often asked the following: I just took a new job. Should I roll over my old 401K or leave it where it is? The best course of action is often a bit nuanced. Sometimes, keeping it where it is may be the best thing to do. In other circumstances, it could cost you dearly. Regardless, here are 5 definite blunders that you should avoid.
Blunder 1: Not doing a direct rollover.
You can roll over a 401K using two methods. The first is a 60-day rollover and the second is a direct rollover. With a 60-day rollover, the employer is required by IRS rules to withhold 20 percent of the amount as taxes and the 80 percent remainder is paid directly to you. Within 60 days, you must fund the new retirement plan account. Otherwise, you’ll be taxed on the total you should have rolled over, and face a possible 10 percent penalty.
As an example, suppose you have $100,000 in a 401k that you do a 60-day rollover with. The employer will withhold $20,000 as taxes and send you a check for $80,000. You have 60 days to fund the new retirement account — but here’s the kicker. You must fund $100,000, not $80,000, even though the check you received was for $80,000. This means you must come up with the $20,000 from your own funds. If you send a check for $80,000 instead of $100,000, you’ll be taxed on $20,000 and additional 10 percent penalty if under age 59.5. Your best option is to do a direct rollover and have your previous employer make the funds payable to your new retirement account, not to you.
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Blunder 2: Paying higher fees.
You should consider the internal expenses (called the expense ratio) of the funds offered in your old 401k with the funds offered in the new retirement account. If you are thinking of rolling over your old 401k to another 401k with your new employer, make a list of all the funds in both plans and compare the expense ratios of funds in the same asset class. Generally, you should choose the plan with the lower overall costs. But you also need to think about which plan offers better diversification, then weigh that against cost. What if one plan has higher costs but access to multiple asset classes but the second plan has lower costs but lacks access to certain asset classes?
If you’re rolling over to an IRA with almost unlimited investment options, compare the funds you would use in the IRA versus the current 401k. Sometimes it’s better to keep the old 401k. On the other hand, a problem with 401k plans is that investment choices can change and you usually have no say in it. So even if the current lineup looks good, next year’s lineup may not. If you rollover your old 401k to your new employer 401k because the new 401k has better funds and then the new 401k replaces the lower cost funds with higher cost funds, you’re stuck because you usually can’t rollover the new 401k until you leave the new employer.
Blunder 3: Loading up your financial advisor with commissions.
This is a hot topic right now because of the new fiduciary rules coming next year for retirement plans. If you’ve hired a financial advisor and he’s urging you to rollover your old 401k to an IRA that he wants to manage, be very careful. In my opinion, the right way a financial advisor should be managing your portfolio is to manage all of it — including your 401k accounts, no matter where they are located. The fee he’s charging you should already factor in the 401k accounts.
Otherwise you don’t have an investment plan. If your advisor is not managing your old 401k and therefore not charging you a fee for that account, and now he wants you to rollover your 401k to an IRA he manages, make sure you understand the reasons for his recommendation. Is it because he’ll sell you high cost commission loaded funds in the IRA and make more money for himself? Or is it because you’ll have lower cost options in the IRA and a better investment plan?
Click to the next page to see blunders 4 and 5.
Blunder 4: Getting dinged with penalties.
Usually if you withdraw money from an IRA before age 59.5, you’ll have to pay taxes on the withdrawal plus an additional 10 percent early withdrawal penalty (with some exceptions). A little-known rule is that if you leave your employer after age 55, the 10 percent withdrawal penalty does not apply to 401k accounts.
So, let’s say you are age 56 right now and you leave your employer. If you keep your old 401k where it is, you can withdraw money from it now and pay the tax but avoid the 10 percent penalty. Realize that it’s the age at which you separate from the employer that makes this work. If instead you rollover your old 401k to an IRA, and you withdraw money from the IRA at age 56, you will have to pay the 10 percent penalty. This is important because if you’re thinking of early retirement, leaving the money in your old 401k might be the way to go.
Blunder 5: Gambling with your money.
It’s tempting to rollover your old 401k to an IRA with almost unlimited investment choices. But what if you start buying penny stocks and lose everything? The chance of getting burned goes way up if you don’t know how to manage a portfolio. In this case it might be better to keep the old 401k even if that plan has poor investment choices. I’d rather pay high fees in the old 401k and at least get some diversification then to pay no fees in my IRA because my balance went to $0.
As you can see the decision to rollover of your old 401k — like many financial decisions – is multifactorial and depends your specific situation. Make sure you consider all pros and cons
before signing off on the paperwork.
Setu Mazumdar, MD, CFP® is board certified in emergency medicine and he is the President of Financial Planner For Doctors. www.FinancialPlannerForDoctors.comDiscover more Dentist's Money Digest personal finance coverage here.