I mentioned Charlie Munger and his principle of inversion in a recent book review. Sometimes the best solution to a problem comes by approaching it backwards. You can learn more about it by reading the transcript from Mungers’ 2007 USC Law School Commencement speech. An excerpt:
Let me use a little inversion now. What will really fail in life? What do you want to avoid? Such an easy answer: sloth and unreliability. If you’re unreliable it doesn’t matter what your virtues are. Doing what you have faithfully engaged to do should be an automatic part of your conduct. You want to avoid sloth and unreliability.
What can you do to never retire? The broad answer is to never put anything aside for later. A specific answer is to cash out your retirement plan whenever you get the opportunity (i.e. when you leave a job).
Seems simple, right? But according to 401k behemoth Fidelity Investments, more than one third of all participants (35%) cashed out their 401(k) balances when leaving their job in 2013 (source). Among workers aged 20 to 39, a whopping 41% cashed out their 401(k) balances!
Cashing out before age 59.5 means you owe income taxes on the entire withdrawal amount immediately plus an additional 10% penalty. You only get allotted a certain amount of contributions to a tax-advantaged account each year, so that’s even more potential money washed down the drain.
I repeat, the most important thing to do is not cash out your 401(k). What you actually do with it instead is also worth some discussion:
- Roll it over into an IRA. I would say for most people, it is best to roll it over to an IRA at your own custodian. Brokerages like Vanguard, Fidelity, TD Ameritrade, and Schwab all have IRAs that feature low-cost ETFs and numerous other options (Barron’s broker rankings). They all want your money desperately, so if you have any problems at all, just call them up and ask for some help. My mom recently moved her 401k into a IRA at Vanguard and the Vanguard phone rep helped her through everything step-by-step.
- Keep it at your old employer. This may or may not be an option, but if you have a decent plan you could just leave it there for a while. Leaving assets in a 401(k) may allow you do contribute to a “Backdoor” Roth IRA for those people with high incomes.
- Move it to your new employer. It is harder to think of a compelling reason to do this these days. It used to be that some plans offered cheap institutional shares but now most ETFs already offer rock-bottom expense ratio. But again, you may want your assets to stay in a 401(k) and not an IRA for Pre-Tax IRA to Roth IRA conversion purposes.
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I’m thinking about rolling my 403(b) (which is basically the same thing as a 401(k)) into my Roth IRA when I leave my job for a new job in a few years. I figure this will be a good way to get more money into my Roth IRA than I would otherwise be able to, since the Roth IRA contribution limit each year is much lower (about 1/3) of the 403(b)/401(k) contribution limit. Of course, I’ll owe taxes on the total amount, but I’m still fairly young (mid 20s), so I’m thinking that this will pay off in the long run. What do you think?
I think that if your marginal tax bracket at the time of rollover is relatively low and you think it will be lower than the tax rate at withdrawal, then that is a good move.
Also, be sure to have enough to pay the taxes on it even if your bracket is low, to take money out of the money being converted would defeat the purpose.
One consideration before rolling into an IRA is that some states don’t offer as much protection from creditors vs. if the funds remained in an employer’s plan.
Yes that is a consideration, but I consider it a minor one unless you really think bankruptcy is a likely scenario. An IRA is already more protected than a taxable account, and I would rather buy adequate liability insurance to avoid having to use that protection due to a lawsuit in the first place.
At the Canadian company I work for many do not sign up for the pension because they claim they can’t afford it. If we pay 4% our employer will match with 2%. There are many 20 year employees who have let thousands and thousands of dollars in free money pass them by because they just couldn’t afford it.
Can you elaborate on the “backdoor Roth IRA” that you are talking about ?
Direct contributions to a Roth IRA are subject to income limits. However, there is no income limit on contributions to a non-deductible Traditional IRA. There is also currently no income limit on Traditional IRA to Roth IRA conversions. Thus there is a “back door” to a Roth IRA open to everyone. More here:
https://www.mymoneyblog.com/non-deductible-ira-contribution-roth-ira-conversion-rules.html
It’s probably important to expand on Jonathan’s point #3 above about a reason to possibly keep money in a 401K and not roll it into an IRA.
The IRS has a really, really stupid rule which states if all your retirement funds are in a combo of 401Ks and Roths you can do a backdoor IRA.
HOWEVER…. if you have any money in a traditional IRA, the rules for doing a backdoor IRA become incredibly onerous and frankly nearly impossible to figure out.
So that is one reason why you may want to keep money in a former employers 401K which is what Jonathan was referring to above.
“if you have any money in a traditional IRA, the rules for doing a backdoor IRA become incredibly onerous and frankly nearly impossible to figure out.”
I’m sorry, can you elaborate on this complexity? Is there more to it than just paying taxes on the gains in your traditional IRA when you backdoor?
I ask because I recently did this via Fidelity (convert my traditional IRA, which had had funds for a few years, to a Roth) and it was painless; so I’m worried I may have done something wrong.
what? 35-41% of people cash out their 401k balances when changing employers?!! is this an April Fools joke?
Sadly, I don’t think it is!
Hey, this was a tricky “sarcastic” post. Nearly the whole time, I was thinking, “Uh, why would I want to *not* retire?” I can imagine some poor sap who hasn’t had their morning coffee yet reading just a few lines of this post and doing exactly the wrong thing, like, “The broad answer is to never put anything aside for later. A specific answer is to cash out your retirement plan whenever you get the opportunity (i.e. when you leave a job).” =]
One other technical reason, another quirky IRS rule, one might want to leave the money in an employer’s 401k, is that if you go back to work at 55 years old, then quit you will have full access to the funds, not having to wait until 59.5.
For example one could semi-retire at age 50, then go back to work for a few months when one turns 55, then quit. Having full access to millions of dollars. (assuming 401k was maxed from ~21yo to 50 yo)
Retirement accounts are a complete waste. Cash out when you can and invest in rental property. The payout is ridiculously high and the risk extremely low, especially compared to the stock market. Everyone in my family owns rental properties and we get at least a 10% return every year on every single house.
So True!! Thankfully, our family did the exact opposite. Not only did we not cash out my wife’s 401K when we left her job to be a full time mom, we rolled her entire 401K into a Roth IRA. Yes, we took a tax hit the year we did it. But in the long run, with at least 30 more years of growth ahead of us before we plan to touch that money, we have not doubt that we will come out on top in the end. Chances are, that money will double a few times during the next 30 years and when we finally decide to withdraw, it will all be tax free baby!
I have a 401k from a job I left 10 years ago and a traditional ira from before I decided roth was better (due to ability to withdraw principal at any point). I should convert them to roth IRA’s because we adopted 3 kids, qualifying for the ‘adoption tax credit’ so we have ~37k in nonrefundable tax credit over the next 5 years. We don’t pay federal taxes because with 3 extra dependents and me going part-time, we make little enough to not be paying federal taxes. So I really should convert the 401k and traditional IRAs to roth. So we can ‘pay’ that tax liability now. (Not actually pay it because it will be offset by our tax credit.) But it makes me kind of nervous. I should just call up and do it.
Are there any drawbacks to converting to a Roth?