- Choosing the wrong option for what to do with your employer-sponsored retirement account when you leave a job can cost you dearly.
- When looking at investments, remember that a small difference in the fee mutual funds charge can translate to a big difference in how much money you end up with.
- Even if your new employer offers automatic enrollment in a retirement plan, the contribution percentage may not be enough.
- Your company offers a retirement savings match? Check the vesting schedule to make sure you’re not leaving money on the table when you depart for your next job.
Moving on has become quite the popular career move lately.
The official government stat tracking folks who quit their job hit an all-time high in three different months last year. And it looks like the I’m outta here movement still has plenty of steam. According to a Fidelity survey, nearly half of adults under the age of 35 say they are likely to be in the market to make a job change.
As liberating and invigorating as it can be to make a move to a better job, or maybe take some time off, it also puts you at greater risk of screwing up your retirement planning.
If you had a 401(k) at your old job, once you quit you have a maddening array of choices about what to do with it, including cashing it out. Which, let’s face it, is appealing if you need a break for a few months to hit the reset button, or want to be able to wait to land the job you truly want, or need a cushion to launch into full-time self-employment.
That said, cashing out comes at a high cost that deserves careful consideration.
“Your investments are the one place where you aren’t trading time for money, in fact you are making money in your sleep,” says Nick Foulks, of Great Waters Financial, a Minneapolis wealth management firm. Cash out and you have irrevocably given up the future compound growth of that money.
And then there’s the challenge of what’s next retirement-savings-wise. Maybe you land at a new job that doesn’t pony up a workplace plan; just 50% of private sector workers offer this benefit. That lands you in the same risk pool as folks going the self-employed route: Your future retirement security depends on you setting up your own retirement savings ASAP.
Even if your next job comes with a 401(k), there are plenty of potholes to navigate around there as well.
“Don’t let things happen by default; make decisions by deliberation,” advises Catherine Collinson, president of the Transamerica Center for Retirement Studies. After all, it’s your retirement that’s on the line.
Here are potential retirement savings pitfalls to consider when you job hop, and how you can navigate around them.
About Your Old 401(k) …
Inside this article
Risk 1: Your ex employer kicks you out of your plan
This can happen if you have less than $5,000 saved in the plan. There are two ways this plays out:
The plan sends you a check for the account balance. If you keep the money, rather than reinvest it in another retirement plan, such as an Individual Retirement Account (IRA), you are going to owe the IRS some serious change. Sixty days after that check is cut, it is deemed to be a withdrawal. That means you owe a 10% early withdrawal penalty if you are younger than 55 in the year you leave a job, as well as owing income tax on the withdrawal.
The plan moves your money into an IRA. Yep, they can do this. And it may be a super helpful way to keep you on the saving straight-and-narrow. But there’s one big caveat: If the IRA they moved you into charges high fees (more on this soon), you don’t want to leave it there. With just a small amount of elbow grease, you can move the money to an IRA at any discount brokerage, and from there you will be able to invest in super-low-cost index mutual funds or exchange traded funds.
Risk 2: You want to cash out, and use the money for a really good reason.
Once you leave a job, you are allowed to withdraw the money in your account. Foulks, of Great Waters Financial, totally gets that the motivation to cash out is often well-placed amid the Great Resignation. “For many people, the idea is to use the money to lower their monthly expenses, or stretch the period of time they don’t have to work, or reduce the type of pay necessary for the work they want to do.”
Good intentions can still be a costly mistake. Use that money now, and you’ve raided your retirement savings and lost a whole lot of future compound growth. That $10,000 today that you leave marinating for another 35 years will be worth more than $75,000, assuming a 6% annualized rate of return.
Moreover, Foulks warns that when you cash out you could be walking into an IRS hellscape. As mentioned earlier, if you are under age 55 when you leave a job and then cash out, you will owe a 10% early withdrawal penalty, plus income tax. That not only reduces what you actually pocket, but Foulks warns that in the process, by reporting more income you could end up bumping yourself into a higher tax bracket for the year.
Risk 3: You just leave it where it is.
As long as you have at least $5,000 in your account, many plans will let you leave the money parked right where it is. Granted, that’s a lot better than cashing out. But it can still be a mistake because:
Your old employer’s plan is expensive. OK, with full apologies, it’s sort of important to wade into some fin-jargon right now. Your 401(k) account is invested in one or more funds. And each fund charges an annual fee. It’s called the expense ratio (ER), and is deducted from a fund’s gross return before crediting your account with the net (after ER) return.
Some funds have super-low ERs, others not so much. The less you pay in this fee, the more of your money keeps growing for your retirement.
For stock funds inside a 401(k), the average ER is around 0.40% per year. That means if your fund gains 10%, your account will be credited with a 9.6% return. Seems piddly, but it adds up.
Let’s say there are two identical stock index funds. One is inside your 401(k) and charges an 0.50% ER. The other owns the same exact stocks tracking the same exact index, but you bought it at a discount brokerage where you moved your money into an IRA (more on this soon, don’t worry), and that fund charges 0.10%. If we assume you have $25,000 in both today, and the index (before expenses) returns an annualized 6%, over 30 years, your investment in the more expensive fund will be worth around $125,000 compared to nearly $140,000 in the less expensive fund. That’s $15,000 more just because you care about paying low expenses.
Your old employer’s plan doesn’t have low-cost index mutual funds. There are two broad approaches to investing. Hire a manager to pick the investments (what’s known as active management), or invest in an index fund that tracks a benchmark, such as the S&P 500 stock index (known as passive investing).
We’ll spare you all the details and cut to the bottom line: Active managers have a lousy track record consistently delivering returns that beat comparable index funds. If your plan is stubbornly active, or the broad stock index funds charge more than 0.10%, you likely can do better moving your money out of the plan.
It makes it harder to have a unified investing strategy. If you make a habit of leaving 401(k)s behind every time you move on, you could needlessly be upping your risk. “The underpinning of retirement investing is asset allocation,” says Collinson. “Having accounts in different places makes the asset allocation analysis that much more difficult.” Think cat herding. You don’t want to be doing that with your retirement savings, right?
If you are staring at any of those risks, you have two workarounds:
Option 1 for moving your old 401(k): Your new employer’s plan. If you land at a job with a plan, check if it (a) allows you to move your old 401(k) into your new account and (b) the expense ratios on its funds are indeed rock-bottom.
Option 2 for moving your old 401(k): Set up an IRA rollover account at a discount brokerage (for example: Fidelity, Schwab, TD Ameritrade or Vanguard) or a robo advisor (for example: Betterment, Sofi, Wealthfront).
With either option, just be clear you want to do a direct rollover (from Plan A to Plan B). That way the money gets moved into your account without any tax bill.
Risk 4: You have company stock in your 401(k) and understandably have no clue what NUA is.
Before you consider an IRA rollover,you’ll want to get up to speed on a tax strategy with the god-awful name of Net Unrealized Appreciation (NUA).
“This can mean saving tens of thousands of dollars in tax,” says Foulks. The key is that you need to separate company stock from the rest of your retirement money when you roll it over to an IRA. If you’ve got a nice chunk of company cash, it might be helpful to hire a financial pro to help you sort through it all. The XYPlanning Network is full of certified financial planners (CFPs) you can hire an a project or hourly basis (virtual or face-to-face).
Risk 5: You decide to retire early and roll it over into an IRA.
This is solely for folks in their mid 50s contemplating an early retirement. You might actually want to think twice before moving your money to an IRA.
Normally if you pull money out of an IRA before turning 59½ you owe a 10% early withdrawal penalty. But if you are at least 55 in the year you leave a job, but not yet 59½, you can take money out without owing the penalty.
If you instead rolled over your 401(k) into an IRA at age 55+ and then took money out before 59½, you would be smacked with the 10% early withdrawal penalty. Why? Because the tax code says so. Don’t waste your time pondering the lack of logic there.
About Retirement Saving After Changing Jobs …
Risk 1: Your next chapter doesn’t include a retirement plan delivered on a silver platter.
If your next job doesn’t come fully loaded with a workplace retirement plan, it’s time to suck it up and create your own. The longer you wait, the harder it will be to land at retirement with the money you want.
It may not be anyone’s idea of a good time, but setting up an IRA is not a very heavy lift. You can do it online in a matter of minutes and set up an automatic transfer (weekly, monthly, quarterly) from your checking account into your retirement account. Self-employed? In addition to the common flavors of IRAs (traditional and Roth), you are also eligible for a SEP-IRA, which may enable you to save a whole lot more than with the traditional or Roth.
Tip: Discount brokerages such as Fidelity, Schwab, TD Ameritrade and Vanguard offer low-cost index mutual funds and exchange traded funds (ETFs). If you want to hand over the asset allocation job, robo advisors such as Betterment, SoFi and Wealthfront will handle that, for a relatively low annual fee.
Risk 2: You land a great job with a great retirement plan, but you can’t start from the get-go.
According to Vanguard’s annual report of the 401(k) plans it runs for employers, 30% of plans don’t allow new hires to immediately start saving. Granted, most just make you wait a few months, but some outliers make new hires wait a full year before they can contribute to the 401(k).
And nearly one-third of plans run by Vanguard make you wait a year before they will start to kick in a matching contribution.
All of that is an argument for doing some retirement saving on your own while you wait. You can contribute up to $6,000 in 2022 to a traditional or Roth IRA ($7,000 if you are at least 50 years old).
Risk 3: You have a new workplace plan and you are thrilled to be auto-enrolled. Curb your enthusiasm.
Many firms automatically enroll new employees in the company retirement plan, and give employees the option to back out. Most new hires stick with the plan, which is great. Auto-enrollment is a fantastic nudge that gets people rolling on their retirement savings.
But many employers maddeningly drop the ball with the next step. When auto-enrolling new employees, the plan also has to choose what percent of a worker’s salary will be automatically contributed to their retirement account. And they typically come up way short on this.
According to T. Rowe Price, the average deferral rate is around 4.5%. Even if you (eventually) get a company matching contribution, it likely won’t be more than half of what you are contributing. If you are contributing, say, 5%, that means your employer might kick in 2.5%. Your all-in contribution rate of 7.5% is way short of the 10% to 15% savings rate that experts recommend.
And it gets worse! Your employer matching contribution is typically based on however much you are contributing. And plenty of employers set your default contribution rate so low you won’t qualify for the maximum match from your employer. Grrr.
Thankfully there’s a quick and easy workaround. Contact HR and tell ’em you want to set a higher contribution rate. At a minimum, you always want to make sure that your contribution rate is high enough to trigger your employer kicking in its maximum contribution. An even better goal is to make sure that your contribution and your employer’s contribution add up to at least 10% of your salary, with 15% being an even better win.
Risk 4: You mistime your next job hop.
The money you contribute to your 401(k) is 100% yours from day one. The money your employer adds to your account as a matching contribution can come with a string attached. According to Vanguard, about half of plans impose a “vesting schedule” on their contribution.
Plain English: A vesting schedule is the formula for how slowly the employee contribution becomes 100% yours.
Some plans use a “cliff” formula: Their contribution becomes 100% yours only after, say, one year, or two years from the contribution. Leave before your cliff date and you get zippo of that match. Other plans use a “grading” formula, where a portion becomes 100% each year. For example, under a three-year formula, one-third of the employer contribution becomes irrevocably yours after one year, another third after year two, and the final third after year three.
Each year’s matching contribution is run through whatever vesting schedule your plan uses.
The ace move here is to know your vesting schedule. If possible, you want to avoid leaving right before another chunk of matching contributions is about to become 100% yours. For example, if it’s March and you’re ready to make a move, but another chunk of matching contributions will vest in May, making sure you stay at least that long can add a few thousand dollars to your retirement plan that is all yours. #leavewithmore is a big win.