If you have left an employer or changed jobs over the years, you may have a 401(k) (or several) that you’re not quite sure what to do with. In this post we will review your options and the pros and cons of each. Although the focus of this post is 401(k) accounts, this applies equally to other work-sponsored plans, like 403(b) and 457 accounts.
Options for your old 401(k)
You generally have three options for a 401(k) account held at a previous employer:
- Keep the 401(k) at your previous employer
- 401(k) Rollover - Roll the 401(k) into your current employer's 401(k)
- 401(k) to IRA Rollover - Roll the 401(k) into an IRA
A fourth option is to take a cash distribution. But taking a cash distribution subjects you to income taxes, you will lose tax-deferral benefits, and you may also be subject to an additional 10% penalty if you are younger than 59 ½. As a result, we will not focus on this fourth option.
Before we review the pros and cons of each of these options, let’s identify the key considerations in making this decision.
1. Account Balance
The amount held in a previous employer’s 401(k) is an important consideration in deciding how to handle the account. If it’s a relatively small balance, you may choose to move these assets to your current employer's 401(k) or an IRA in order to consolidate and simplify your finances. If it’s a larger balance, then evaluating the quality of investment options and fees is more worthwhile, as these features will be more impactful on your retirement portfolio growth.
2. Investment Options
Your employer is responsible for selecting the funds offered in the 401(k) plan, as well as many other features of the plan (the custodian, matching contributions, profit-sharing, vesting, and more). As a result, 401(k)’s can vary significantly from company to company.
With an IRA, you generally have far greater options in your investments. But with these options and control comes greater responsibility.
Therefore, when weighing your options, compare the investment options of your previous employer to your current employer, as well as to your IRA.
As with investment options, the fees charged by 401(k) plans can also vary significantly from company to company. And these fees will have a meaningful impact on your account balance over time. 401(k) plan fees must be disclosed and you can request these fee disclosures from your previous and current employers for comparison purposes.
With an IRA, you have greater control over these fees. You can open an IRA with many financial institutions at zero cost, although your account may be subject to asset minimums or other factors. Your financial advisor may also manage your IRA on your behalf, but in this case be cognizant of the fees being charged by your advisor and potential conflict of interest.
If your advisor charges an asset-based fee, understand how your advisor's fees will change if they manage additional assets in your IRA. Your advisor's fee could be compared to the 401(k) plan fee.
4. Tax Strategies (Backdoor Roth & Roth Conversions)
Deciding to keep your assets in a 401(k) or roll them into an IRA has tax planning implications:
- Backdoor Roth contributions are generally ill-advised if you have a Traditional IRA. In order to make Backdoor Roth contributions, you may decide to keep your assets in a 401(k).
- Roth conversions are not a common feature of 401(k) plans. If you would like to take advantage of Roth Conversion strategies, you may decide to roll your 401(k) into an IRA.
5. Simplicity and Ease of Management
The ease with which you can manage your various retirement accounts must also be considered. All else equal, it would be great to have one single “retirement account.” But we often find ourselves with our current 401(k), accounts at previous employers, plus an IRA and maybe a Roth IRA too.
We can still strive for simplicity in our personal finances and use this simplicity consideration as a deciding factor after evaluating investment options, fees, and tax planning implications.
Comparing Your Three Options
With these key considerations in mind, let’s compare your three options.
1. Keep the 401(k) at your previous employer
You do not necessarily need to close or move your 401(k) account when you leave an employer. If you like your previous employer’s 401(k) investment options and platform, you may keep your account. However, if you do not have at least $5,000 in your 401(k) account, your previous employer may choose to close your account and transfer the balance to an IRA or send you a check.
- Keep your investments and platform – If you prefer the investment options and platform of your previous employer, you can keep it.
- Backdoor Roth available – If you are above the income limit to contribute directly to a Roth IRA, you may be making backdoor Roth contributions. Keeping assets in a 401(k) instead of rolling the assets into a Traditional IRA can keep the backdoor Roth option viable.
- Added complexity – Having to keep tabs on previous employer 401(k) accounts is the major drawback of keeping these accounts open. Employees are moving jobs more often and keeping track of old investment accounts can become more and more challenging. If you do choose to keep your 401(k) at a previous employer, be sure to have a regular process to review the account and its investment options, rebalancing as necessary. (A personal finance app is a good tool for tracking these accounts
2. 401(k) Rollover
If you like the plan offered by your new employer, prefer the simplicity of fewer 401(k) accounts, and/or want to keep the backdoor Roth option open, you can roll your 401(k) into your current employer’s plan.
- Consolidate into a better plan – If you evaluate your current employer’s plan and find it superior to a previous employer, take advantage by rolling assets into your current employer's plan.
- Simplicity and Ease of Management – All else equal, fewer accounts are better. Having your assets in one place makes it easier to manage and understand your asset allocation.
- Backdoor Roth available – Again, keeping assets in 401(k) plans instead of rolling them into an IRA makes backdoor Roth contributions viable.
- “Locked in” to current employer’s plan – Once you roll assets into your current employer’s 401(k), it is very challenging to move these assets again penalty-free until you leave this employer or retire. And you will be subject to your employer's plan-level decisions around investment options, fees, and more. If your employer decides to change major plan features in six months or five years, you will not have an opportunity to go back to your previous employer’s plan or move the assets into an IRA.
3. 401(k) to IRA Rollover
The third option is to roll your 401(k) account into a new or existing IRA. IRA’s offer you greater flexibility and control and are a great option to consolidate multiple “old” 401(k) plans. But with greater control comes greater responsibility and, as a result, some of the pros and cons cut both ways.
- Greater Control – Managing your own IRA allows you far greater control over the custodian, fees, investment options, and more. Fees in particular can be dramatically lower for IRAs when compared to 401(k) plans, and can have an equally dramatic impact on your retirement account growth.
- Simplicity and Ease of Management – If you have several 401(k) accounts at previous employers, these may be consolidated into one IRA (or a Traditional IRA and Roth IRA if you have Traditional and Roth 401(k) assets).
- Roth Conversions – Rolling assets from a 401(k) to an IRA may open up the possibility for Roth Conversions.
- Greater Responsibility – More control means more responsibility. You will have far greater investment options in an IRA, and a correspondingly far greater range of potential outcomes. 401(k) plans are imperfect, but your investment options are generally limited to diversified funds. IRAs do not have the same guardrails and can lead to concentrated portfolios or speculation.
- No more Backdoor Roth – Due to the pro-rata rule, it generally is no longer beneficial to make Backdoor Roth contributions if you have assets in a Traditional IRA. For high-earners, rolling 401(k) assets into an IRA will make Roth IRA contributions prohibitive.
Be Aware of Conflicts of Interest
If you are working with a financial advisor, a 401(k) rollover creates a potential conflict of interest that you should be aware of and discuss with your advisor. A Certified Financial Planner (CFP®) is required to disclose this conflict of interest when making a recommendation to rollover your 401(k) to an IRA.
The conflict arises from the way many advisors are paid (Assets Under Management (AUM)) and which account types advisors can manage (IRAs, not 401(k)'s). Your advisor can likely directly manage your IRA accounts, but not your 401(k), and may earn a higher fee by rolling assets from your 401(k) to an IRA.
It's important for both you and your advisor to understand this additional fee when weighing the pros and cons of your 401(k) decision.
This conflict of interest is an excellent example of the conflicts I strive to avoid through my fee structure. By charging based on net worth, we evaluate every decision based on what will optimize your entire financial picture. Rolling your 401(k) to an IRA may be in your best interest, but we will make this decision without this potential conflict.