If you have parted ways with your previous employer, you may be wondering what happens next with your retirement account.
Generally you cannot keep contributing to an employer-sponsored plan, such as a 401(k) or 403(b), if you have left that employer, but you do have several options when it comes to managing those savings going forward – and they can all impact the size of your future nest egg.
Determining which is right for you requires a thorough review of your financial picture and long term goals. “It’s not something that should be decided on in a vacuum,” said Brian O’Sullivan of Commonwealth Financial Group in Boston. “It should be integrated with your overall profile.”
Whether you are in a new job or not, you generally have the option to leave your old retirement plan where it is, as long as your balance is at least $5,000 (if it’s less than that, your employer may be able to automatically cash you out). You will not be able to actively contribute anymore, but the money that is already there will remain invested and participate in investment gains (and losses), based on how you set up your asset allocations.
The “do nothing” plan is certainly the easiest route, and if your old plan has access to quality investments that are now closed to new investors or can offer them for lower fees, it may also make good sense. But remember that if you originally allocated your retirement plan funds in a way that no longer reflects your current investment goals and you don’t commit to adjusting your allocations over time, it could be costly. (Learn more: Are you in the wealth transfer zone?)
An old plan that is invested too aggressively means you might face more volatility than you are comfortable with. On the flip side, a too-conservative investment strategy means your money is not taking the appropriate amount of risk to meet your goals, and you could be missing out on greater opportunities for growth.
It is all too easy to fall into the old “out of sight, out of mind” trap with a retirement account you are no longer actively contributing to. And an investment style that is out of sync with your current needs and risk tolerance could mean less retirement income for you when the time comes, so be wary of letting old plans sit idle.
Roll into your current employer’s plan
Depending on your personal situation, you may be able to consolidate by rolling the balance from your old plan into your new employer’s plan. Just make sure to ask your former plan administrator for a direct rollover so the money never touches your hands – if it comes to you as a check that you have to deposit in the new plan, the transaction is considered a taxable distribution. The amount distributed, including the amount of the income tax withholding, would be subject to ordinary income tax, plus an additional 10 percent early withdrawal penalty if you are under age 59½.
Consolidation is a pretty common route, and the upside is that you don’t have to keep track of multiple retirement accounts or remember to update your asset allocations in a separate, older account as your investing style and risk tolerance change.
But what if you don’t have a new account to roll funds into?
If you are between jobs or at an employer that does not offer a retirement plan, there are some other options to consider.
Roll into an annuity
You may want to investigate, for example, whether an annuity would be wise. Though annuities do not replace retirement savings plans, they can act as another source of income in retirement. (Learn more: Does an annuity fit your retirement goals?)
Because there are several different kinds of annuities available and understanding the pros and cons of each can get complicated, it is a good idea to seek out a financial professional to help you determine whether an annuity is right for you.
Roll into an IRA
Another option is to move your funds into an Individual Retirement Account, or IRA. As with 401(k)s, 403(b)s and other defined contribution plans, IRAs have their own sets of rules.
There are two basic kinds of IRAs: traditional and Roth. The big difference is in when they are taxed.
Traditional IRAs, like 401(k) plans, defer taxes until retirement, when you may be in a lower tax bracket and therefore would owe less tax on the earnings.
Roth IRAs, on the other hand, are funded with after-tax dollars, so there is no immediate deduction benefit, and there are eligibility requirements associated with starting a Roth IRA. But the earnings grow tax-free, which can yield a bigger potential payoff for retirees.
There are other differences, too, so make sure you understand the options before going with either a traditional IRA or a Roth IRA. The IRS publishes an IRA comparison chart, comparing the rules for Roth and traditional IRAs, on their website that may help you get started. There are also rules about what type of account can be rolled into another type of account. For those details, check out the IRS Rollover Chart.
Cash out your retirement balance
There is one final road you can choose when determining how best to manage your retirement account when you leave your job, but it comes with a big red flag.
Your contributions, and any matching contributions from your former employer for which you are vested, are yours to do with what you choose. That includes cashing out.
This can be tempting. We could all make use of a sudden windfall.
But remember that when you put that money away, it was specifically earmarked for retirement. The longer you leave money in your plan, the more opportunity it has to benefit from compound interest in a tax-deferred setting. If you drain your savings now, you are robbing yourself of that money’s potential to grow.
“Someone who cashes out their 401(k) savings will feel the sting of having thrown away savings that the cashed-out balances would have accrued when they retire, and they will also lose money immediately after making the cash-out decision,” J. Spencer Williams, president and CEO of Retirement Clearinghouse, noted in a column. “In other words, cash-outs hit you in your wallet not once, but twice.” 1
What the second bite? You still owe income tax on the amount you take out (except in the case of a Roth 401(k), which is funded with after-tax dollars), and the IRS charges most taxpayers who are under age 59½ a 10 percent early withdrawal penalty. (That penalty is waived in certain hardship situations.)
Also, keep in mind that the dollar figure that appears on your statement may be far less than what you would receive, after applying vesting schedules (for employer contributions) and deducting amounts for income tax withholding.
If you are not retiring now, most financial professionals advise against taking your retirement money to pay for short term expenses.
Making the right financial move
Most experts would agree that just thinking at all about what to do with your old retirement account means you value your savings, and that’s a good thing. By taking a little time now to figure out how to make the money in an old retirement account best serve you so, you will be much better positioned to retire on your own terms when the time comes.
Learn more from MassMutual…
This article was first published in November 2016. It has been updated.
1 J. Spencer Williams, “Cashing out your 401(k) hits you twice”, MarketWatch, 2016.