Your 401k represents a powerful investment tool for your retirement. It gives you a tax-advantaged vehicle for taking your salary, matching it with contributions from your employer, and growing it through an investment portfolio of your choice for your retirement. Making use of a 401k through your employer is a great idea and one you should pursue wholeheartedly.
What do you do if you leave your job or are laid off? That 401k account, after all, is tied to your employer; you’ll have to find something to do with that money. There are several options available to you for what is called a 401k rollover; here, I’ll cover a few and give you some ideas about where you can place your money for maximum returns.
The Basics of a 401k Rollover
A 401k rollover, basically, is when you have to take the funds from your current 401k and place them somewhere else, in another qualified plan like an IRA. You could just liquefy the assets and take your funds in cash, but doing so subjects the entire amount to state and federal income taxes plus a 10% penalty from the IRS (in most cases). In this case, there is also a mandatory 20% withholding tax that goes toward your distribution, which means you’ll only get 80% of your amount, plus the penalty.
Since we want to avoid 10% of our vital retirement funds being siphoned off from the top, we generally prefer to rollover the funds into another qualified contribution plan and continue to save and invest and grow our net worth.
A rollover itself isn’t that complicated. After you check with eligibility from your current employer, and consult with a trusted advisor, it’s a manner of filling out paperwork.
Where to place the money, though, is the big question.
What Are Your Options?
There are a few options available to you when pursue a 401k rollover. The first is to rollover your funds into a new employer’s 401k account. Doing so gives you the exact same advantages as you had before with your original 401k, and you get to avoid paying a 10% penalty or any other distribution-related taxes and penalties.
The downside to this is that your employer-matched contribution may be lower, but really you are just transferring money from one side to the other. Of course, the return you could get with this option may not be as great as with other options. Plus, you are paying high investment fees (401k plans tend to have higher investment fees than other similar options) and lose a lot of flexibility, since your plan is still tied up with an employer.
One of the most popular choices is to rollover your 401k funds into an individual retirement account (IRA). An IRA has a big drawback of not being matched by an employer, so you lose access to what really is free money from your employer. But you gain a lot of flexibility, particularly if you choose a brokerage IRA – one that allows you to buy individual stocks, bonds, mutual funds, and even CDs and options and make your portfolio the way you want. This can deliver a substantial return, but it can also result in fees that you pay per trade (plus additional fees if you trade exchange-traded funds).
Another option is to choose another type of IRA – a mutual fund IRA, or an IRA held by a mutual fund company (like T. Rowe Price, Vanguard, etc.). This takes away a good bit of your flexibility, since your money can only be invested in what the company owns, i.e. its own proprietary mutual funds. For some investors, that may be a good call, especially for those who only want to put it somewhere with a trusted company and let it grow and accumulate with minimal interference.
The good news about this type of IRA is that there aren’t commissions, and usually aren’t any fees, either.
Finally, you can choose to roll your 401k into an annuity, which is basically a series of payments for a certain period of time in exchange for control of your principal. There are two types: immediate and deferred. The deferred option is best for those who still want to maintain control of their principal and continue to invest in the market.
Getting the Best Return
We can safely say that you’ll get the worst return by withdrawing your money early and getting hit with taxes and fees. But what’s the best return?
For most investors, going to a low-cost mutual fund IRA is the best option, if only because they are generally cheaper – which means you are taking less out of your account. A brokerage IRA will cost more, but you could potentially gain more in the market. Then again, you could lose more – which, for something as important as your retirement, may not be something you want.
One word about annuities: They’ve become more popular lately, but cost money (especially for additional protection), don’t provide any additional tax advantages, and aren’t flexible. For older plan holders, though, they may be worth pursuing; consult your advisor for more information.