The Huge Mistake You Could be Making with Your 401k – And How to Fix it Quickly

It’s your last day of work. You say your goodbyes, eat your farewell cake, and pack up your desk. But if you don’t rollover your old 401k too, you might be making a big financial mistake.

You actually have a few options for your retirement account when you leave your employer. Most companies, but not all, allow you to keep your retirement savings in their plans after you leave. So you could in theory walk away without giving a thought to your 401k. But that would be a costly mistake.

First of all, there’s something to be said for consolidation. Let’s say you’ve had four different jobs, each with a different 401k brokerage (i.e. one uses Fidelity, one uses Vanguard, etc.). Now, imagine keeping track of those four different accounts, with four different locations and logins, for the next 30+ years. Sound fun? Didn’t think so.

Second of all, even if your employer allows you to keep your contributions in their fund, they might not maintain your investments for you. For example, when I left my consulting job, all of my investments were liquidated into a money market account – essentially cash. If I had left my money sitting there until retirement, it would have grown at a whopping 0.01% a year. And that’s quite common – many employers will roll over your 401k for you into a money market fund after you’ve left the company.

Considering that just $5,000 gaining 8% annual returns for 30 years could grow to $50,000 by retirement, that measly money market growth rate could cost you a ton of potential money, even if you don’t have a lot sitting in your account.

So, what should you really be doing when you leave? Granted, there might be some rare reasons you want to keep your old account put, like if you have access to a special, low cost investment. In that case, congratulations: your work is limited to monitoring your account. Another option is to cash out your 401k, but I really do not recommend this. If you withdraw before you’re 59½, you’ll have to pay ordinary income taxes on the money, plus a 10% early withdrawal penalty. On top of that, employers have to keep 20% set aside for the IRS.

Instead, for most of you, your best bet is to rollover your 401k into an IRA. Note, the rollover IRA is not a Roth IRA, so you won’t have to pay any taxes on it when you rollover. Instead, it’s like a traditional IRA where you are taxed on the money when you withdraw it in retirement.

There are two ways to rollover your 401k. The first, and easiest, route is to do a direct rollover (aka trustee to trustee rollover). In this case, you would open an IRA at your brokerage of choice (generally where your other accounts are held, even non-retirement accounts), and then direct your 401k brokerage to move the funds to the new account. For example, let’s say your old 401k is at Vanguard and you want to open a Fidelity rollover IRA. Vanguard will either transfer the money electronically to Fidelity for you, or send you a check made out to Fidelity, which you’ll then deposit into the rollover IRA.

The other method is an indirect rollover, but again, I don’t recommend this one. In this case, the 401k plan writes a check to you, and you have 60 days to roll it over into an IRA. But this method is a total pain in the butt. If a check is made payable to you, your employer must withhold 20% of the rolled-over amount for the IRS, even if you plan to roll it over within 60 days. But you still have to invest the full withdrawal within 60 days to avoid the 10% penalty and taxes, so you’ll have to use your own cash to invest the 20% that was withheld. You’ll only get the missing 20% back when you file your tax returns.

More tax return work? That’s a total nightmare scenario you’re better off avoiding. Instead, make sure you initiate a direct rollover where the withdrawal is never in your name. If you have questions or are worried you’ll make a mistake, just give the IRA financial institution a call. You’ll find that brokerages tend to be very helpful when you’re trying to put money into one of their accounts.

That money comes into your rollover IRA as cash, so your next step is to reinvest it. The good news is that you have significantly more investment options in an IRA than in a 401k. Unlike in your 401k, which probably offer less than 50 fund options, in your IRA you can invest in individual stocks, ETFs, mutual funds, bonds, and CDs.

Again, your IRA financial institution will generally have resources to help you make your investment decisions. As always, my rule of thumb is to avoid high investment expenses. Generally, you can choose investments that offer much lower investment expenses in your IRA than you can in your 401k. My rollover IRA is invested in high dividend stocks, low cost ETFs, and a low cost mutual fund. And if you’re confused about how much you should be putting aside for retirement, free tools like Personal Capital’s retirement planner could show you if you’re on track for retirement.

All in all, the rollover process should only take a few hours, but can make a huge impact on your savings by the time you hit retirement.