I’ve had the good fortune of working for employers that offered a 401k plan ever since I got my first job out of college. I always knew the importance of saving in a 401k to reduce my taxes as well as lay a foundation for retirement. But I never knew what to do with my 401k once I left those jobs. As a result I did nothing, which is probably the second worst option (right behind cashing it out).
Once you leave an old employer where you’ve held a 401k you typically have four options:
- Keep it in the old employer’s account. This option lets you keep your existing mutual funds so long as you meet the minimum balance and they don’t force you out.
- Roll it over to an IRA.
- Roll it over to a new employer’s 401k.
- Cash it out. Do not ever do this! You’ll end up paying taxes plus fees and in general you might as well just burn your money.
Obviously of those four I don’t consider one of those a valid option under almost every possible circumstance.
If you meet the minimum account balance requirements then the first option, keeping it in the old employers 401k, is the default action. So when I moved on from my first job I let it stay. When I left my second employer I let them both stay. And then when I did some financial cleanup a couple years back I came to my senses and I rolled them both into an IRA. My inaction cost me money and I’m the only one to blame.
So long as you fill out the proper paperwork, doing a rollover is relatively easy and doesn’t result in penalties or taxes like a cash out. Rolling an old 401k into your new employers account is not used very commonly, but does at least offer the ability to merge them to make management easier. But in my experience moving out of a 401k without penalties is almost always the better option. Why? It’s all about choice and fees.
You see, in a normal 401k plan you’re typically limited to choices of some small set of mutual funds. And those choices? Well if you work for a large company you might have some OK choices like index funds or “investor class” shares with lower management fees. But you’ll definitely be limited in your choices, and as the article I linked mentions if you’re in a small company you likely aren’t getting great (or maybe even good) options in the first place.
Moving to an IRA opens up the entire portfolio of your brokerage firm, and in my case that meant being able to buy my favorite Total Stock Market Index ETF, VTI which boasts a ridiculously low fee of 0.05%! Why is that important? Because management fees are taken right off the top of your returns. So if my old funds and VTI had the same performance, with VTI I’d only have to take 0.05% off the top where my old funds typically charged 1%+.
That seemingly small amount adds up tremendously over time:
If I held $10,000 over 20 years and earned 7%, what’s my take after fees for some fee rates? With VTI’s 0.05% fees I’d end up with $38,312. Let’s compare that to a fund charging only 0.58%, a relatively good fee rate. Our take? $34,447. Just buying a super low fee fund can save us just shy of $4,000 dollars!
A 1.16% fee, which is around the average for large blend funds? Down to $30,643. Now we’re saving nearly $8,000 – a very large percentage of our returns.