By Brittany N. Cox,
Registered Investment Advisor at Nestlerode & Loy Investment Advisors
The days of working for one employer for 50 years with a pension and a token of service seem to be fading away for most Americans. Workers now migrate from one job to the next in search of fulfillment or more income. According to thebalancecareers.com, the average person changes jobs 12 times during their career while spending five years or less in every job. In January 2018, the Bureau of Labor Statistics reported the median tenure was 4.3 years for male employees and 4.0 years for females.
With job changes becoming more frequent, it’s important to know what you should do with your employer retirement plan when you change employers. Of course, there are different options to choose from. Most people roll their 401(k) over to an IRA in their own name. The benefit of this is having more investment options and more control for the owner. This option is helpful if a person frequently changes jobs and accumulates multiple plans which are hard to track. If they are all held in one account, they can be diversified easier and tracked in one place.
Many people forget about their old plan and simply leave it where it was. If this is preferable for your individual situation, you should be sure to know the costs to stay in the plan. Some 401(k) plans offer mutual funds with higher than average underlying fees and often the investment options are limited. One caveat to keep in mind is the “Rule of 55” which allows employees who are laid off, fired, or quit their job between the ages of 55 to 59½ to take money from their 401(k) without the assessment of the 10% early withdrawal penalty. Of course, this would still be a taxable distribution and the Rule of 55 only applies to your current 401(k) plan at your current employer, so leaving behind your account will not fall into the rule if you are below age 55.
One other option that I’ve recently heard a few of my friends talking about is cashing out their 401(k) plan when they change jobs. This is very rarely the best option available unless you are in a dire financial situation. According to a 2012 report by Transamerica Center for Retirement Studies, 25 percent of unemployed or underemployed workers cashed out their 401(k) plans. This number is astounding to me. When you cash out your 401(k) or IRA for a lump sum, you will owe taxes on the entire amount of the withdrawal, plus a 10% early withdrawal penalty if you are under 59½. This means for a person in the 20% tax bracket, their retirement account worth $200,000 will net them $140,000 cash.
One person I discussed this with said, “When I find a new job, I’ll just cash in my 401(k) to pay off my mortgage and live debt free.” This sounds like a great idea, living debt free in your 30s, right? Let’s dig deeper into the numbers. The typical interest rate for a mortgage today is approximately 4%. So, if you have a home mortgage for $180,000 at 4%, you’ll pay about $129,000 in interest over 30 years. Chances are, you’ve already paid some of this at the time of leaving your employer for a new job. However, if you invest that $180,000 for 30 years at an average market return rate of 6%, you’ll end up with about $1,033,828. So, the total cost of your mortgage for 30 years is about $309,000, but your retirement account could end up over $1 million. I would argue that most often it is not beneficial to use your retirement savings to pay off debt, even if you will start to contribute at your new job. The average market returns are higher than the interest rate on most loans.
The best option for an individual who is leaving or has left their employer is to sit down with a financial advisor and review their retirement plan. This will ensure you are making the right choice whether to roll your 401(k) assets into a new IRA, combine multiple 401(k)s into one IRA, leave the assets in the 401(k) plan, or use the cash for other things. Having a financial plan will help you see the bigger picture and keep your focus on the future and your goals. Cashing out your retirement plan could set your plan back and mean working longer to make up the lost returns.