These days, the average company offers its employees a 401(k) retirement plan. These plans replaced the traditional pension plans that our grandparents had. The face of retirement savings changed in 1978, when Congress amended the IRS Code by adding section 401(k). This stipulated that employees are not taxed on income that they choose to receive as deferred compensation rather than direct compensation. The law became effective in 1980 and by 1983 almost half of large firms were offering a 401(k) plan. By 1984 there were 17,303 companies, large and small, offering 401(k) plans.
It is possible for the 401(k) account to stay active for many years after an employee departs the company, though the account must begin to be withdrawn beginning the first of April of the calendar year after the account holder reaches age 70½ or April first of the calendar year after retirement, whichever is later. In the last ten years, some companies started charging a fee to ex-employees who maintained their 401(k) account with them. To avoid those possible fees,(and to have more investment options), you should consider a 401(k) rollover. When an employee leaves a company, the money can be rolled over into a new 401(k) account hosted by the new employer. You can also consider an IRA (individual retirement account) at an independent financial institution. A third option is to roll it directly into an IRA held at a mutual fund company.
401(k) rollovers are often preferred because they are not subject to extra taxes or to withdrawal penalties. Since retirement accounts like 401(k)s are funded with pre-tax dollars, they grow tax-deferred. If you were to withdraw the money prior to age 59 ½, you’d pay a stiff penalty—10% — and, of course taxes on the money. So don’t let confusion about how to do a rollover, or worse — apathy about money, keep you from making a smart choice with your 401(k) account.
Do be aware of some of the 401(k) rollover rules. It can take several months to process a rollover request. One of the major holdups is the matching contribution many companies make to their employees’ accounts. In general, it is easier for companies to do the “matching” part as a lump sum every quarter, so figuring out what you should get right now, as you leave the company, can take time.
As you’re shopping for a spot to park that little retirement nest egg, don’t forget to research the fees. You may decide to keep your account with your old employer if the fee structure is low. Larger companies can negotiate for funds with lower costs than individuals can get on their own. Here’s how the fees can add up and you might never notice. Imagine Joe, a 35-year-old employee, leaves his job at Widget Co. and leaves behind $33,000 in a 401(k). Widget Co. did a great job of negotiating low fund fees with the investment firm. If we assume a modest eight percent annual return before the fees are deducted, Joe might expect to have $404,105 in that account when he retires at age 70. If Joe rolled that balance into a retail IRA, he’d only have $366,424 at age 70. That’s a difference of $37,681!
Taking a little time to understand your 401(k) rollover options will save you a bundle down the road. We’ll explore more of your retirement options and the pitfalls to avoid in subsequent posts.
More on the history of 401(k) accounts