Don’t fret when you change jobs and need to deal with your old 401k. Follow these steps and soon you’ll be back to drinking your marg 🙂

Voluntarily going to the dentist. Waiting in line at the DMV. Reading the U.S. tax code. All of these things are probably (hopefully?) at the bottom of your list of enjoyable activities. When you switch jobs, you will likely be faced with the question of what to do with your 401k. This could be viewed in the same vein as the previous three– but it’s not. Today, I will share my experience with rolling over my 401k and some tips for how to think about this process.

Important disclaimer: I am not a CPA, nor should this be construed as legal or financial advice. Just think of this as a friend talking about how he maximized his rollover.

What is a 401k?

As a reminder, a 401(k) is one of the most common type of retirement accounts. 68% of workers have the ability to contribute to these accounts, but only 41% do so. Every company has slightly different programs, but here are the basics:

• A part of the benefits package your company offers, you have the opportunity to contribute a certain amount of your paycheck to a retirement account sponsored by your firm
• This can be pre-tax or after-tax, I’ll explain about this difference in greater detail below
• You may receive a match from the company.

This “match” is an amount that your employer agrees to contribute to your account, on your behalf. It may be:

• 100% match (usually up to 3% or 5% of your income)
• 50% match (up to a higher amount).
  • You would receive $0.50 per $1 you contribute up to the limit. So, if you have a 50% match up to 10%, that means to receive a full 5% of your salary matched from your employer, you must contribute 10% of your income to the 401k.

Another employer-specific nuance is the vesting period. This is the period before which the employer match amount is yours to keep, no matter what. If you were to leave your company or get fired before then, then only the vested amount is yours to keep. Got it?

Here’s a real life example:

Congratulations, you are employed at XYZ Enterprises! You earn $100,000 a year in salary, with no bonus. Additionally, XYZ Enterprises offers a 401k match program of 5% and a 3 year vesting schedule. That means if you contribute $5,000 per year, your company would also contribute $5,000 to your account on your behalf. However, should you contribute $10,000 or any value more than $5,000, you will still only receive the $5,000 match.

Here’s how the vesting schedule works (assuming $5,000 in contributions each year and a 5% return, compounded annually):

• If you leave prior to the end of the first year, you have the $5,000 that you put in (with whatever returns that you achieved) and $0 from the employer match.
• If you leave after 1 year, you have $5,004 (monthly contribution compounded annually at 5%) and 33% of the employer’s $5,004 matching amount. In this case, that is $1,651.32.
• If you leave after 2 years, you have $10,258.20 (again, monthly contribution compounded annually at 5%) and 67% of the employer’s matching account, $6,872.99.
• Finally, by leaving after 3 years, you have $15,775.11 and 100% of the employer’s matching account, another $15,775.11.

Never (if you can do so without debt) contribute less than the value of your employer’s matching amount. There is no such thing as “free money” but this is as close to it as you get.

What are the Tax Implications?

Ah, taxes. Everyone loves paying them, right? No matter which 401k option you choose, you have to pay taxes at a certain point. A pre-tax 401k, as the name suggests, means that you contribute money before paying taxes to an account. So, if you make $100,000 and contribute 5% ($5,000), your actual pre-tax income would be $95,000. The income that you pay taxes on will be $95,000 rather than $100,000.

A related benefit of contributing to a pre-tax 401k is it is a great way to reduce your taxable income. However, know that you will still need to pay taxes– when you withdraw your money (or convert it to a Roth 401k), you will pay income taxes at the level of your income at that moment.

On the other hand, a Roth 401k is similar to the Roth IRA. The money you contribute to your Roth 401k is after-tax money, meaning that you have already paid taxes on it. However, once you contribute to your Roth 401k, it can grow tax-free and you will not need to pay taxes upon withdrawal, as long as you wait until you turn 59 1/2.

Rollover Process

With that background about the 401k out of the way, let’s get into what happens when you switch jobs. You have several options:

• Leave the account alone.
• Receive a check.
• Rollover to your new 401k.
• Rollover to a Traditional/Roth IRA.

Let’s examine each.

Do Nothing:

If you so choose, you may leave your existing 401k as-is. You should have no issues accessing the funds whenever you so choose, just know you will not be able to contribute any more funds to the account since you are no longer employed by that company. In times of extreme volatility (the past year, anyone?) you can avoid losses by staying in the market. More on that in a minute.

There are three main drawbacks to this approach.

• You cannot add additional funds to the balance. You will; however, be charged the same fees as you were previously. Even if your company paid them for you (which is rare), they will no longer since you are not an employee any more.
• The more accounts you have, the more complicated everything is. Do you want to know how much you have saved? You’ll need to remember the logins for each account– assuming you can remember the name of the firm with which you have money. Do you want to convert to Roth? Well, you might have to do that twice.
• Investment options for each 401k plan are different. One employer might have access to every fund under the sun while another might only offer 5-10 funds.

This may not matter to you, but let’s say you have $50,000 in a 401k at one company and $50,000 in another. The old company offers few funds and you only average 3% compounded annually. The newer company offers many more and you average 5% returns, compounded annually. Here’s what this difference looks like after 10 years (for simplicity, assume no additional contributions, though the difference will remain the same either way):

• If you keep the two funds separate, you’ll have $67,195.82 in the old fund and $81,444.73 in the new fund for a total of $148,640.55. Pretty good, right?
• If you combine the two funds, you’ll have $162,889.46 after 10 years. That’s $14,248.91 more just by transferring money that’s already yours!

Receive a Check:

DO NOT CHOOSE THIS OPTION!!!

One option you have when you change jobs is to cash out your 401k and receive a check. Sounds great, right? Remember that this is a retirement account so this money is supposed to cover your second margarita on the shuffleboard course in Palm Beach (aka retirement). Additionally, you will need to pay taxes on the entire amount.

Let’s say you are filing single and have $170,000 in taxable income this year. You are withdrawing $50,000 from your 401k. Guess what, you need to pay taxes on $220,000 now! So that $50,000 might be worth less than $30,000. How?

• Well $170,050 is the upper limit of the 24% tax bracket and $170,051 is the lower limit of the 32% bracket in 2022.
• By adding $50,000, you will pay 32% federal taxes on almost the entire amount.
• Plus, you’ll be responsible for state income taxes and a 10% early withdrawal penalty if you are younger than 59 1/2 years old.
• Assume you pay 3% in state taxes. That means you’ll pay 35% taxes on the $45,000 (10% early withdrawal).

Withdrawing $50,000 gives you a $29,250 check. Ouch, that’s much worse and you won’t get the magic of compounding growth. 🙁

Rollover to a New Employer’s 401k:

The next option is to rollover your existing 401k to your new employer’s 401k. This is just a fancy way of saying you transfer the money from your old account into your new account. While the process is extremely detailed, it does not have to be complicated. There are programs that will work with you (generally for a fee) to conduct the rollover. However, all it takes is a few minutes of your time. Here is the process:

1. If you have a new 401k setup, great! If not, set up the 401k with the new employer and wait for a couple of days to be set up before continuing.
2. Once established, pull up your existing 401k and navigate to the “Start a rollover” page.
3. Simultaneously, pull up your new 401k account information
4. Fill out the form on the “Start a Rollover” page, ensuring that everything is 100% accurate. Do not fill in anything relating to taxes or a bank account. You should be rolling one pre-tax 401k to another pre-tax 401k. If so, you will not owe any taxes.
5. You may have the option to have the old firm deposit the funds into the new 401k’s funds. If that is the case, great. You may still wish to request a check be mailed to you to ensure no issues with receipt of funds. *This is not the same as having the funds cashed out– do not do that as you will need to pay taxes*
6. Call the firm that offers either the new or existing 401k if you get stuck!
7. Once you have completed everything, I highly recommend calling to confirm everything was done properly. When I called, I had less than 2 minutes of wait time with both Charles Schwab and Fidelity.
8. After 2 business days, you should receive the check. Deposit it into your new 401k account and you are all set!

Rollover to Traditional/Roth IRA:

A final option many choose is to rollover to an IRA. While I have lumped Traditional and Roth together, it is important to acknowledge the differences between the two processes.

Quick notes:

• A Roth IRA holds after-tax money, while a traditional IRA holds pre-tax money.
• Similarly, your 401k is either a pre-tax or Roth 401k (post-tax).
• If you have money in a pre-tax 401k, you can rollover to a Traditional IRA tax- and penalty-free.
• If you have money in a Roth 401k, you can rollover to a Roth IRA.
• You cannot roll money from a Roth 401k to a Traditional IRA.
• If you attempt to rollover a pre-tax 401k to a Roth IRA, you will pay taxes.
  • Some people recommend this approach. If you value tax-free growth over all else, can stomach paying taxes on the funds now and are not near a higher tax bracket, this can be a good option. Stay tuned for a full-length article on the benefits on pre-tax 401k versus Roth 401k and the benefits and issues with each.

Why would you want to rollover a pre-tax 401k to a Traditional IRA or a Roth 401k to a Roth IRA? An IRA offers many more options for investment than a 401k. You can purchase any number of funds or stocks rather than the chosen few that your company’s plan allows for in a 401k.

One thing to note: when you rollover your Roth 401k to Roth IRA, you have a couple of days between when you request this and when you receive the funds. I recently completed this process and was shocked when I received nearly 7% less than I was anticipating.

I called customer service and was told that this value was due to the market value of my Roth 401k decreasing. To add insult to injury, in the days between selling the funds and the check arriving, the market went up nearly 2% each day. As I said before, during times of extreme volatility, you may receive a different amount than you were anticipating. The good news is I still have a few years to earn that back 😉

Which Option is Best?

Unless you really value the benefits of a Roth IRA such as tax-free growth, there are only two options: Rollover to 401k at New Firm or Rollover to Traditional/Roth 401k. Which is right for you will depend on what you want out of investing. Are you happy to set it and forget it? The 401k may be the best spot for you. Want to have more control over your investments? You may prefer rolling over to an IRA.

When I say Maxing Out Memories, most of the time we think about the today– vacations, concerts, and the like. Saving for retirement is extremely important and unfortunately many don’t think about it until it is too late. Keep thinking about tomorrow but also enjoy today!

Evan