What Should I Do With a 401(k) From My Old Job?

Question: I've switched jobs a few times and I have an old 401(k) that I'm not sure what to do with. Should I roll it over? Is it OK to just let it sit there?

Answer: In most cases, it makes the most sense to roll your money over into an IRA or into your new 401(k) plan, if that's allowed. (Leaving the money behind or rolling it into your current employer's 401(k) may or may not be allowable--the specific bylaws vary by plan, so check on that first.)

That said, there are some good reasons to consider leaving your assets within the confines of a former employer's plan. (Though you will not be able to make additional contributions to your balance if left in a former employer's plan, your money will still enjoy tax-deferred compounding.)

Here are some considerations to help you weigh the pros and cons of both decisions.

Roll It Over Reason #1: You can do better on costs in your new plan, or on your own. Do some due diligence on your new plan and your old plan. (Brightscope is a good resource for evaluating and comparing 401(k) plans.)

Often, 401(k) plans charge administrative fees, and many times the participants themselves bear these costs. Other times, plans use high-cost share classes of mutual funds that have extra fees embedded inside of them. Those extra fees tend to be more prevalent in plans of smaller employers, because small 401(k) plans have fewer investor dollars.

Larger plans can charge lower fees because they have scale advantages. With your assets pooled with other plan participants', your new employer's plan may have access to institutional share classes of funds, which typically feature very low costs and may be unavailable to investors with smaller balances.

If your new plan has reasonable expenses, low-cost options, and a robust investment lineup, you might want to consider rolling your assets from your former employer's 401(k) into your new one, if that's allowed by the plan provider.

Or you could roll your 401(k) balance into a no-fee IRA at a discount broker or fund company. This may be your only option if your new employer's 401(k) plan will not accept a rollover from your old 401(k) plan. A potential benefit of doing this is that unlike at 401(k)s, where you must choose from a preset menu of investment selections, you can buy almost anything and put it in an IRA--namely, low-cost funds, target-date funds, or exchange-traded funds.

Reason #2: Streamline and simplify your accounts. This point may seem obvious, but it shouldn't be understated, in my opinion: Having fewer accounts can help you streamline your monitoring and rebalancing efforts. And having your assets in one place can allow you to better assess your overall asset mix.

You can give your portfolio a checkup using Morningstar's Instant XRay tool. Just input your holdings and the dollar amounts, and the tool will show you how your money is allocated across asset classes, sectors, geographical regions, and more.

Reason #3: Avoid a forced rollover or payout. Some plans have automatic rollover or force-out provisions. That means that if you have less than $5,000 in your 401(k), your old employer can remove your money from the plan. In fact, if you have less than $1,000 in the plan, the plan administrator is allowed to write you a check to get your money out of the plan. That doesn't sound too bad, but you have 60 days to invest that money it in an IRA or your new company's plan (if allowed). If you don't, your payout will get a substantial haircut. (It will be subject to ordinary income tax, plus a 10% early withdrawal penalty.)

If you have between $1,000 and $5,000 in your former company’s 401(k), the plan administrator can roll your assets into an IRA to get them out of their plan. This may not sound too bad either, but the investments you will end up with in a “safe harbor” IRA are cashlike assets designed to protect principal, not necessarily grow or outpace inflation. (In other words, not ideal for investing for retirement.)

The administrator running your previous employer's 401(k) is required to notify you 30-60 days before they automatically roll over your money or send you a check, but if you've moved or changed your email address, you may not receive the message. It's best not to find yourself in this situation; if you know you have an old 401(k) with a low balance, proactively relocate those assets yourself. Leave It Behind Reason #1: The old plan has good investment options and low fees. The flip side of the scenario discussed earlier may be true: Your former employer's plan has lower or no administrative fees, or it may be larger and thus have access to cheaper institutional share classes of funds than your new plan. Or your old plan may feature a better investment lineup.

There are also certain investments, such as stable-value funds (essentially, a mix of bonds in an insurance wrapper that behaves like a high-yielding cash investment), that are only available to 401(k) investors whose plan offers one.

Reason #2: You own company stock in your old 401(k). If you have company stock in your 401(k), rolling company stock into an IRA could be a mistake.

The tax code allows special tax treatment of company stock under "net unrealized appreciation" rules that can potentially save you a lot of money, especially if the stock has grown in value since you acquired it.

Your cost basis is taxed at your ordinary income tax rate. But rather than paying ordinary income tax on the market value of the shares of company stock when you sell them, the net unrealized appreciation rule allows you to pay capital gains tax on any appreciation over and above your cost basis when you sell the shares. Capital gains are taxed at a preferred rate--investors in the highest tax bracket will pay 20%, while investors in the middle brackets will pay 15%, and investors in the bottom two tax brackets will not owe any income tax on capital gains.

The hitch is that you have to roll the company stock directly from the 401(k) into a taxable brokerage account in-kind, in a lump sum distribution, following a "triggering event" such as leaving or getting fired your job, turning 59 1/2, or becoming disabled. You can no longer use the NUA rules once if the stock is liquidated in the plan and distributed in cash, or rolled over to an IRA. (Read more here.)

If this situation applies to you, check with a tax or financial advisor to help determine the best course of action.

Reason #3: You may need earlier access to your money. IRA investors and most 401(k) investors must wait until age 59 1/2 to be able to access funds in their accounts if they want to avoid the 10% early withdrawal penalty. But there is an exception to this rule for employees who quit, retire, or were fired the year they turn 55 or after. If you find yourself in this specific circumstance, leaving the money in the 401(k) plan of the company you're departing could make more sense than rolling the money over into an IRA and tying it up for an additional 4 1/2 years. (Check with your plan first to make sure this would be allowed.)

Reason #4: You think creditors may come knocking. Hopefully you wouldn't find yourself in this situation, but in case you do: 401(k) plans offer a better level of protection from creditors than IRAs do. While 401(k)s and 403(b)s are fully protected from creditor judgments, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 protects IRAs from creditors up to $1,000,000 (adjusted for inflation).

Just Don't Cash It Out! Whatever you do, don't succumb to the temptation to take the lump sum in cash. As discussed earlier, you'll take a big haircut on the money via early withdrawal penalties, and you'll miss out on decades of compounded growth.

If you're rolling over the balance, avoid temptation and just plain hassle by having your former 401(k) provider make the check payable to the new IRA or 401(k) provider and send it directly to them, rather than to you. If the check is made out to you, 20% of the balance will be withheld for income tax. You'll then have 60 days to get that money deposited into an IRA or another 401(k); if that deadline comes and goes, the distribution will count as a withdrawal and you'll owe ordinary income tax and a 10% early withdrawal penalty if you're not 55 or older.

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