If you have an old 401k because you changed jobs or you’re not fully self-employed, you might have to decide what to do with that 401(k) account you contributed to every payday. Before you do a rollover IRA, which most people will tell you what you should do, you may want to hit the pause button. A rollover IRA may not necessarily be the best option. In this article, we will share three equally great options you may want to consider when deciding on what to do with your old 401(k).
Option One: Move your old 401k to your new 401k.
This option only makes sense if your new 401(k) fund lineup is solid. How will you know if it’s solid? There are two considerations to help you decide. One, if you see the words “institutional index” in a couple of the fund options, then you know that’s a good, solid fund lineup. Institutional class index funds essentially are really low-cost funds that are typically only made available to large institutions like pension funds or foundations, but your employer is making those institutional index funds available for you. The second thing that I look for is the words “brokerage link.” Typically, this would be found at the end of the 401k fund lineup. Not a lot of companies have this, but this brokerage link option, if it’s available in your new 401k, will give you the option to buy pretty much any mutual fund or ETF that’s available on the platform. So, what I mean by that is if your 401k is housed in Fidelity and it has this brokerage link option, once you enroll in the 401(k), then you can pretty much buy any mutual fund or ETF that’s available in the Fidelity platform, and that’s a really great option.
Option Two: Keep your old 401k where it is rather than do a rollover IRA.
I know that might seem odd, but sometimes the best action is to take no action. If you’re a goalkeeper for a soccer team, and your opponent’s power forward is racing towards you with the ball, research has shown that the best course of action is actually to stay standing in the middle of the goal, at the center of the goal, at least until you see the trajectory of the ball. Now, it only makes sense to keep your old 401k if you already have those institutional class index funds that I mentioned earlier available in your old 401k. Also, if you already have that brokerage link in your old 401k, then you really want to keep that account because you’ll have access to all of those mutual funds or ETFs in that platform. Now, you don’t really want to overdo this because according to the Bureau of Labor Statistics, on average, each of us will hold around 12 jobs in our lifetime, and you don’t really want to have 12 401(k)s floating around by the time you retire. You may be wondering why you wouldn’t just choose to do a rollover IRA for all of your old 401(k)s and keep it simple. In short, this could cause negative tax implications if you ever choose to do a Backdoor Roth IRA, which you may want to do if you earn too much to contribute directly to a Roth IRA. We explain this in more detail in our Backdoor Roth IRA blog.
Option Three: Roll your 401K over to a Roth IRA.
Now, you have to listen carefully because this is not for everyone. This move could trigger both state and federal income taxes if your 401(k) is pre-tax and you are moving it to a Roth account. This only makes sense, rolling it over to a Roth IRA, if you expect to be in the low tax bracket this year (22% tax bracket or lower). Now, this might happen if you expect to be in between jobs for most or part of the year, or you’re planning to take a sabbatical and won’t have much-earned income for the tax year. If you are going to be in one of the lower tax brackets and you move your pre-tax 401(k) to a Roth IRA, you are taking advantage of paying lower taxes on that transfer this year compared to when you retire and may be in a higher tax bracket when you withdraw your pre-tax funds.
To recap, if you have an old 401k, before you do any rollover IRAs, make sure you consider your other three equally great options. Deciding what to do with your old 401k is really a crucial financial decision and I strongly recommend you to seek out an expert, credentialed financial planner to make sure that you’re doing what is really the best for you.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help middle-class professionals achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.