401k Options When You Change Jobs

Jane Young, CFP, EA

In addition to the other commotion related to changing jobs, you need to decide what to do with your 401k account.  You have four possible options; leave it with your employer, transfer it to your new employer’s plan (if allowed), transfer it to a Rollover IRA or cash it out.  Unless you’re in a dire situation, avoid withdrawing your 401k funds.  Cashing out your 401k will result in taxation of the full amount at regular income tax rates as well as a 10% early withdrawal penalty if you leave your job prior to age 55 and don’t qualify for an exception.  Additionally, you will forfeit the opportunity to earn tax deferred, compounded growth on the hard earned money you have put away.

If you have at least $5,000 in your 401k account, you should be able to leave it with your old employer.  The decision to transfer your 401k or leave it in place largely depends on the quality and variety of investment options and the fees charged by the plan.  Some 401k plans provide access to low cost institutional funds that have lower or comparable fees to those available in an IRA.  If the fees are high and your choices are limited consider moving your account.  Another downfall to leaving your 401k with your old employer can be the danger of neglecting or forgetting about it, resulting in the failure to monitor and rebalance your account.

When changing jobs you may want to consider transferring your 401k to your new employer’s plan. Again, this should only be considered if they have a wide variety of low cost investment options.  You also may find it more convenient to have all of your funds in one place.  A disadvantage to this choice is once you transfer your 401k to a new employer’s plan you may lose the option to later move it to another plan or custodian.  You are locked in if the new plan administrator makes changes to the investment offerings or fees that you don’t agree with.  Alternatively, some advantages of a 401k over an IRA include the ability to borrow against your account, as long as you remain employed, and a 401k may offer greater protection against creditors than an IRA.

Your final option is to transfer your 401k to a Rollover IRA.  A Rollover IRA can provide you with the greatest variety of investment options including mutual funds, individual stocks, bonds and CDs.  You have the freedom to choose from a wide variety of custodians including discount brokerage firms and mutual fund companies to get the best quality, selection, service and cost.  If you decide to transfer your 401k to an IRA; select a custodian, open an IRA account, and ask your 401k administrator to process a direct transfer to your new account.  To avoid negative tax consequences be sure the check is payable to the custodian, not directly to you.

Strategically Withdraw Money for Retirement

Jane Young, CFP, EA

Jane Young, CFP, EA

After years of contributing money to 401k plans and Roth IRAs you are finally ready for retirement and face the dilemma of how to best withdraw your retirement savings.  Many retirees have several sources of income such as pensions, social security and real estate investments to help cover their retirement needs. Review your annual expenses and determine how much you need to pull from your nest egg for expenses that aren’t covered by other income sources.

One way to manage your retirement income needs is to create three buckets of money.  The first bucket is for money that will be needed in the next twelve months.  This money should be fully liquid in a checking, savings or money market account.  The second bucket is money that will be needed over the next five years.  At a minimum, hold money needed in the next five years in fixed income investments such as CDs and short term bond funds.  By investing this money in fixed income investments it is shielded from the fluctuations in the stock market; avoiding the agonizing possibility of having to sell stock mutual funds when the market is down.

Consider buying a rolling CD ladder where a CD covering one year of expenses will mature every year for the next four to five years.  After you spend your cash during the current year a new CD will mature to provide liquidity for the coming year.

The third bucket of money is your long term investment portfolio.  This should be a diversified portfolio made up of a combination stock mutual funds and fixed income investments.  Every year you will need to re-position investments from this bucket to your CD ladder or short term bond funds to cover five years of expenses.  Rebalance your long term portfolio on an annual basis to keep it well diversified.

In conjunction with positioning your asset allocation for short term needs, you need to decide from which account you should withdraw money.  Conventional wisdom tells us to draw down taxable accounts first to allow our retirement accounts to grow and compound tax deferred, for as long as possible.  Gains on money withdrawn from a taxable account are taxed at capital gains rates where withdrawals from a traditional retirement account are taxed at regular income tax rates and withdrawals from Roth IRAs are generally tax free.

Withdrawing all your money from taxable accounts first isn’t always the best solution.  You need to analyze your income tax situation and strategically manage your withdrawals to avoid unnecessarily going into a higher tax bracket.  Additionally, the taxation of Social Security is graduated based on income.  After starting Social Security, you may be able to minimize taxation of your benefit by taking withdrawals from a combination of taxable, traditional retirement and Roth accounts.  Do some tax and financial planning to strategically minimize taxes and maximize your retirement portfolio.

Should You Contribute to a Traditional 401(k) or a Roth 401(k)?

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Many large employers have started offering employees the choice between a traditional 401(k) and a Roth 401(k).  However, only a small percentage of employees have elected to contribute to a Roth 401(k).  The primary difference between the two plans is when you pay income taxes.  When you contribute to a traditional 401(k) your contribution is currently tax deductible, but you must pay regular income taxes on distributions taken in retirement.  Contributions to a Roth 401(k) are not currently deductible, but you pay no income taxes on distributions in retirement.  As with your traditional 401(k), your employer can match your Roth 401(k) contributions, but the match must go into a pre-tax account.  

There are several differences between a Roth 401(k) and a Roth IRA.  In 2014, annual contributions to a Roth IRA are limited to $5,500 plus a $1,000 catch-up contribution if you are 50 or over.  Contribution limits on Roth 401(k) plans are much higher at $17,500 plus a $5,500 catch-up contribution, if you are 50 or over.  Additionally, there are income limitations on your ability to contribute to a Roth IRA, and there no income restrictions on contributions to a Roth 401(k).   Additionally, upon reaching 70 ½ you must take a required minimum distribution from a Roth 401(k).   You are not required to take a distribution from a Roth IRA at 70 ½.  However, you do have the option to transfer your Roth 401(k) to a Roth IRA prior to 70 ½ to avoid this requirement. 

The decision on whether to invest in a Roth or traditional 401(k) depends primarily on when you want to pay taxes.  If you are currently in a low tax bracket and believe you will be in a higher tax bracket in retirement, a Roth account may be your best option.  On the other hand, if you are currently in a high tax bracket and you think you may be in a lower tax bracket in retirement, a traditional 401(k) could be your best option.  A Roth 401(k) is generally most appropriate for younger investors who are just getting started in their careers or someone who is experiencing a low income year.  People who are in their prime earning years may be better off taking the current tax deduction available with a traditional 401(k). 

Unfortunately, it’s difficult for most of us to know if our tax bracket will increase or decrease in retirement.  It is also hard to know if tax rates will increase before we reach retirement.  From a historical perspective, tax rates are currently low and some believe future rates will be increased to help cover the rising federal debt.  Amid this future uncertainty, your best option may be to split your contribution between a Roth and traditional 401(k).  This will give you some tax relief today and some tax diversification in retirement.

The Difference Between an Roth IRA and a Traditional IRA

Jane Young, CFP, EA

Jane Young, CFP, EA


One of the biggest decisions associated with saving for retirement is choosing between a Roth IRA and a Traditional IRA. The primary difference between the two IRAs is when you pay income tax. A traditional IRA is usually funded with pre-tax dollars providing you with a current tax deduction. Your money grows tax deferred, but you have to pay regular income tax upon distribution. A Roth IRA is funded with after tax dollars, and does not provide a current tax deduction. Generally, a Roth IRA grows tax free and you don’t have to pay taxes on distributions. In 2013 you can contribute up to a total of $5,500 per year plus a $1,000 catch-up contribution if you are over 50. You can make a contribution into a combination of a Roth and a Traditional IRA as long as you don’t exceed the limit. You also have until your filing date, usually April 15th, to make a contribution for the previous year. New contributions must come from earned income.
There are some income restrictions on IRA contributions. In 2013, your eligibility to contribute to a Roth IRA begins to phase-out at a modified adjusted gross income of $112,000 if you file single and $178,000 if you file married filing jointly. With a traditional IRA, there are no limits on contributions based on income. However, if you are eligible for a retirement plan through your employer, there are restrictions on the amount you can earn and still be eligible for a tax deductible IRA. In 2013 your eligibility for a deductible IRA begins to phase out at $59,000 if you are single and at $95,000 if you file married filing jointly.
Generally, you cannot take distributions from a traditional IRA before age 59 ½ without a 10% penalty. Contributions to a Roth IRA can be withdrawn anytime, tax free. Earnings may be withdrawn tax free after you reach age 59 ½ and your money has been invested for at least five years. There are some exceptions to the early withdrawal penalties. You must start taking required minimum distributions on Traditional IRAs upon reaching 70 ½. Roth IRAs are not subject to required minimum distributions.
The decision on the type of IRA is based largely on your current tax rate, your anticipated tax rate in retirement, your investment timeframe, and your investment goals. A Roth IRA may be your best choice if you are currently in a low income tax bracket and anticipate being in a higher bracket in retirement. A Roth IRA may also be a good option if you already have a lot of money in a traditional IRA or 401k, and you are looking for some tax diversification. A Roth IRA can be a good option if you are not eligible for a deductible IRA but your income is low enough to qualify for a Roth IRA.

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