The Error-Proof Portfolio: Know the Options for Your Small Orphan 401(k)
A direct rollover to a new IRA is usually the best and most tax-efficient strategy.
As I noted in a column last week, most investors are better off rolling over their old 401(k)s into an IRA when they leave their former employers, though there are certain situations when staying put in an old 401(k) plan is better than doing a rollover. One good reason to stick with a former employer's plan is if it's gold-plated, featuring very low-cost institutional share classes of great funds, a stable-value option (a rare example of an investment for which there is no analog outside of the 401(k) environment), and no layer of administrative expenses. Another reason is if there's the potential that you might be sued because 401(k)s generally offer better legal protections than IRAs.
But participants with small balances are apt to find they don't have as much leeway as do 401(k) investors who have amassed bigger kitties: They can't necessarily stay or go as they please. A balance of $5,000 is the magic threshold; if a 401(k) total is above that level, plan participants have the flexibility to stay put in the old plan or roll the money into an IRA, factoring in the considerations I laid out last week. But if a balance is below that mark, it's worth familiarizing yourself with your options as well as the possible routes that your employer could take with your small balance if you don't take action yourself.
If Your 401(k) Balance Is Between $1,000 and $5,000
If your balance is lower than $5,000, your employer can legally remove your money from its plan after you've left the company. The idea is that employers would rather not have to shoulder administrative costs for participants who are no longer with the company, and accounts with small balances are more costly to maintain than large ones. Your employer must notify you before doing so, at which time you'll have the opportunity to roll the money into an IRA or into your new employer's plan. (Only do so after you've done your homework and determined it's a good plan.)
If you decide to go the rollover route, don't feel obligated to stick with your existing 401(k) provider, even though that will often be the easiest route. (You're likely to receive a rollover form enabling you to do so.) Instead, consider opening your own IRA and investing in one or a handful of core-type funds that Morningstar considers best of breed; Morningstar's Premium Fund Screener can help you identify core-type funds that are best of breed and meet your minimum purchase requirements. Conducting a direct rollover--whereby your plan provider deals directly with your IRA provider--is the easiest and most tax-efficient route.
If you do nothing when your former employer sends you a notification about your sub-$5,000 401(k) balance, the company can do one of two things. First, it can automatically roll over your assets into an IRA in your name. As with auto-enrollment into a 401(k), auto-enrollment in an IRA means that you'll be defaulted into an investment option, often a target-date fund. This option is better than cashing out and owing taxes and penalties, but opening your own IRA is a better idea because you'll have control over the investment choices.
Alternatively, your employer has the option to cash you out of the plan. If that happens, you'd receive a check with your balance amount, less the 20% that your employer withheld for taxes. You can avoid additional taxes and penalties by rolling over the money into an IRA of your own. If at all possible, use your own money to add back in the 20% that was withheld for taxes. That way the rollover will be entirely tax-free and you won't be subject to the 10% penalty for early withdrawals imposed on people who aren't yet age 59 1/2. Time is of the essence, however--you have 60 days to complete the rollover. If you don't complete it within that window, the Internal Revenue Service will treat the distribution as ordinary income, and you'll owe any taxes due as well as a 10% penalty, assuming you're under age 59 1/2 at the time of the distribution. (Conducting a direct rollover--that is, having your plan provider work directly with your new IRA custodian so you never get your mitts on the money--helps you avoid all of the withholding messiness, and therefore is the far preferable way to go.)
If Your 401(k) Balance Is Less Than $1,000
If your balance in your former employer's 401(k) is less than $1,000, you have even more incentive to do a direct rollover into an IRA. That's because if participants have very low balances in the plan, most providers simply cash them out, sending the participants a check in the amount of their balance, less the aforementioned 20% withholding.
Unfortunately, 401(k) participants in this position are uncomfortably betwixt and between. It's unwise to take the money and run because taxes and a 10% penalty will whittle an already-small balance down even further. But it may also be difficult to find a fund company or brokerage house that will start an IRA with a balance of less than $1,000. In that case, you might have to add some of your own (nonrollover) money to the IRA to meet the minimum. If your income falls below the thresholds for deductible IRA contributions outlined in this article, you may even be able to deduct the additional contribution amount.