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Nowadays most people are familiar with the company 401(k) plan. Conversely, in the last century many companies offered some type of pension plan as a benefit for employees. In those days employees often worked in one place for many years, some for a lifetime. Now it is seldom that employees stay in one job for more than five years. Since 1978, 401(k) plans and other Defined Contribution plans have largely replaced pensions as one of the most common retirement plans used by businesses.
What has changed with the 401(k)?
The biggest change is the fact that most of the burden of funding retirement now falls on the employee. It is up to the employee to make deferrals from their salary into the 401(k) plan to grow their account balance. Oftentimes the employer will match the employee’s contribution up to a certain percentage of gross wages.
The next major change is that now the employee is responsible for the investing of his or her retirement assets. This can be a difficult task for someone with little or no investment knowledge.
What happens if you stop working for the company that sponsored your 401(k) plan?
If you leave your job, in addition to the stress of not being employed or starting a new job, there are important decisions to be made that could have a big impact on your retirement savings.
The path of least resistance may seem to be to “do nothing”. You may be able to leave your money in your previous employer’s 401(k) plan. However, one downside is that some of the 401(k) plan fees that the company used to absorb may now be charged to you. In addition, you will no longer be able to make contributions into the account.
As a terminated employee, you will be given a choice to cash out of the plan. This might seem enticing, especially if you are unemployed. But don’t be fooled, taking out the money can come with a hefty price tag!
First of all, the balance withdrawn will be taxed at ordinary income rates which can be as high as 37%. Secondly, if you are under age 59 ½, there is a 10% penalty for early withdrawal of funds. You also must consider the opportunity cost, for instance these “retirement” funds will no longer be growing tax free or tax deferred. The impact on your retirement nest egg could amount to tens or hundreds of thousands of dollars.
When you are successful in finding a new job, your new company may offer a 401(k) plan. You may be able to do a direct rollover into your new company’s 401(k) plan if the new plan allows it. Contact the plan administrator of the new plan and see if and when you could do this. Perhaps this can be done immediately, but you may have to wait until you are eligible for participation, based on the new company’s policies.
Should you consider a 401(k) rollover?
Many people who leave a company choose to set up a Rollover IRA in order to transfer funds from the 401(k). It is important to use a direct rollover, which is simply a trustee-to-trustee transaction. This way the funds go directly from one plan to another without you receiving the money in between. This will avoid taxes and penalties.
One of the key benefits of rolling over your 401(k) to an IRA is the larger number of investment options. Most company’s 401(k) plans have a limited number of investment options (say, for example, a dozen mutual funds). IRAs allow for total flexibility by giving you the ability to invest in individual stocks, bonds, ETFs, and mutual funds. Having a broad range of investment options can help you diversify and allow your advisor to determine the right investments to align your goals with your risk tolerance and time horizon.
The first step is to look for a financial advisor who can help you compare these various options and the costs to help you determine what best fits your needs. We strongly suggest you work with an advisor who is a fiduciary, meaning he or she must act in your best interest. Lastly, the key to success is to come up with a plan and stick with it!
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Brian Tracy, Self-Development Author
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