Long gone are your grandfather’s days (or great-grandfather’s days), where you stayed at 1 job, retired, and got a pension & gold watch at your retirement party. Odds are extremely like that you’re going to:
If that’s the case, you’ll probably be wondering what to do with your 401(k) from your old job once you move on. This article helps cover what you might consider when making this decision.
Introduction
When you leave your employer, you don’t necessarily have to leave your 401(k) behind. In fact, you might not want to.
Unless you want to liquidate your account (and pay taxes on everything you withdraw), you basically have 3 options:
Keep it there. Although you can no longer contribute to it, your 401(k) can be invested just as if you were still an active employee.
Transfer to another 401(k). If your new 401(k) accepts rollovers from other plans (not all of them do), then this might be appropriate if your new 401(k) has cheaper investments or more investment options.
Roll over your funds to an IRA. This probably is the most common idea you’ve heard of. And why not? Most investment advisors and money managers market all of the benefits as if this is the ‘one-size’ solution that works for every portfolio.
But is that the right thing? Not always. Let’s take a deeper look at these options so we might learn why.
Keep it in a 401(k) or Move to an IRA?
In order to get to the essence of this question, let’s streamline the two 401(k) options into one. This essentially leaves us with:
Let’s look at them a little more in depth. For simplicity’s sake, we’ll assume the pros and cons of rolling into an IRA are the opposite of keeping them in the 401(k).
Keep in a 401(k)
Most people who do this probably don’t actively select this option—it’s the default that occurs when life is too busy for you to do one of the other options. Here are some pros and cons of this:
Pros:
Less work needs to be done right now
You don’t have to set up an IRA if you don’t already have one
If you’re looking to do backdoor Roth conversions, you don’t mix the coffee and cream in your IRA.
Coffee & cream rule: In other words, you’re not adding pre-tax contributions to the after-tax IRA contributions that might be in your account. The IRS pro-rata rule is often known as the ‘coffee and cream’ rule because it treats all IRAs as one big pot. If you’re doing Roth conversions, you can’t just skim off the after-tax contributions and leave the pre-tax contributions for another day…any more than you could skim the cream out of a cup of coffee with cream.
Cons:
You might be limited in your investment options
Your investment options might be more expensive than what you’d have access to in your IRA
Complexity—why have 2 accounts if you could have 1? Or, if you have to have 2 accounts, you should have a clear reason to have the second one instead of consolidating everything.
This is not all the differences, merely some. We can go into painstaking detail, but we won’t. Instead, we’re going to focus on the benefit that relates to the coffee & cream rule—keeping pre-tax contributions out of your IRA. There are a few caveats to consider.
Considerations about keeping 401(k) contributions out of your IRA
Keeping your money in your 401(k) does nothing about the pre-tax contributions that already exist in your IRA. This might happen if:
You’ve been deducting IRA contributions for years, but you started creeping above the modified adjusted gross income (MAGI) and can no longer deduct IRA contributions.
You’ve transferred retirement plan balances from previous jobs into your IRA.
If you’re going to do Roth conversions and you expect them to be tax-free, you have to find a home for all of your pre-tax contributions. Keeping your investments in your most recent 401(k) doesn’t solve this problem, it merely doesn’t add to it.
You have to know how much of your IRA contributions were after-tax to begin with. If you use a tax professional, and you properly report your IRA contributions each year, this probably isn’t much of a problem. Each year’s non-deductible contributions are recorded on IRS Form 8606. To find how much you have in non-deductible contributions (also known as basis), you can refer to line 14 of your most recent Form 8606, which should accompany your tax return. This is a cumulative number, so you only need the most recent tax return.
If you haven’t been documenting your non-deductible contributions, or haven’t reported them to your accountant, you can still find them through the financial institution holding your IRA. Each year, your financial institution issues a Form 5498, documenting contributions to each IRA. Using your Form 5498 and the tax return for that year, you can document whether your IRA contribution was a pre-tax one or after-tax. You can learn more about Form 5498 in this article.
You don’t need to do this if you’ve been contributing to a Roth 401(k). In 2006, the Internal Revenue Code was modified so employers could allow employees to elect Roth-type contributions. If you have been contributing to a Roth 401(k), then those contribution can be converted directly to a Roth IRA without any additional tax.
However, there are a couple of caveats:
You may have contributed to a traditional 401(k) and a Roth 401(k). The traditional 401(k) contributions are considered pre-tax contributions. Any Roth conversions would incur taxes.
Employers can match contributions, but they have to go into a pre-tax account, even if you’re doing only Roth contributions. To do Roth conversions on any vested matching contributions, you would first have to pay tax on them, just like your pre-tax contributions.
Conclusion
So, what’s the conclusion? Don’t believe the marketing hype about rolling your 401(k) into an IRA just because you left your job. You don’t have to. Your next move should make sense in your overall financial plan and your Roth conversion strategy.
If you don’t feel comfortable doing this on your own, you should talk with your accountant or financial advisor. If you aren’t getting the answers you need, then talk with us. We’d be more than happy to schedule a complimentary phone call to see how we might be of service to you.
The foregoing content reflects the opinions of Lawrence Financial Planning, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will recover or react as they have in the past.
