Avoid These Costly 401k Rollover Mistakes

Question: “I recently left my medical group for a new job. Should I rollover my old 401k or keep it where it is?”

While practicing medicine can be frustrating and challenging (that’s an understatement!) -- think lawsuits, nightshifts, patient satisfaction scores, and EMRs -- some specialties such as emergency medicine have the flexibility to move to a different job fairly easily.

One tricky aspect of changing jobs is figuring out what to do with your old 401k from your previous employer.  The laziest option -- just keeping it where it is -- might not be your best option and could cost you dearly. Here are some big 401k rollover mistakes you should avoid:

Mistake #1: Not doing a direct rollover

There are two ways to transfer your old 401k to another retirement plan account. The first is a 60 day rollover and the second is a direct rollover. With a 60 day rollover, the employer is required by IRS rules to withhold 20% of the amount as taxes and the 80% remainder is paid directly to you. Within 60 days you must fund the new retirement plan account. Otherwise you’ll be hit with taxes on the entire amount you should have rolled over plus possibly a 10% penalty.

As an example suppose you have $100,000 in a 401k that you do a 60 day rollover with. The employer will withhold $20,000 as taxes and send you a check for $80,000. You have 60 days to fund the new retirement account -- but here’s the kicker. You have to fund $100,000 not $80,000 even though the check you received was for $80,000. This means you must come up with the $20,000 from your own funds. If you send a check for $80,000 instead of $100,000, you’ll be taxed on $20,000 and additional 10% penalty if under age 59.5. So your best option is to do a direct rollover and have your previous employer make the funds payable to your new retirement account not to you.

Mistake #2: Paying higher fees

You should consider the internal expenses (called the expense ratio) of the funds offered in your old 401k with the funds offered in the new retirement account. If you are thinking of rolling over your old 401k to another 401k with your new employer, make a list of all the funds in both plans and compare the expense ratios of funds in the same asset class. Generally you should choose the plan with the lower overall costs. However you also have to consider which plan offers better diversification and weigh that against the cost. What if one plan has higher costs but access to multiple asset classes but the second plan has lower costs but lacks access to certain asset classes?

If you’re rolling over to an IRA with almost unlimited investment options, compare the funds you would use in the IRA versus the current 401k. Sometimes it’s better to keep the old 401k.

On the other hand a problem with 401k plans is that investment choices can change and you usually have no say in it.  So even if the current lineup looks good, next year’s lineup may not. If you rollover your old 401k to your new employer 401k because the new 401k has better funds and then the new 401k replaces the lower cost funds with higher cost funds, you’re stuck because you usually can’t rollover the new 401k until you leave the new employer.

Mistake #3: Loading up your financial advisor with commissions

This is a hot topic right now because of the new fiduciary rules coming next year for retirement plans. If you’ve hired a financial advisor and he’s urgingyou to rollover your old 401k to an IRA that he wants to manage, be very careful. In my opinion the right way a financial advisor should be managing your portfolio is to manage all of it -- including your 401k accounts no matter where they are located. The fee he’s charging you should already factor in the 401k accounts. Otherwise you don’t have an investment plan. If your advisor is not managing your old 401k and therefore not charging you a fee for that account, and now he wants you to rollover your 401k to an IRA he manages, make sure you understand the reasons for his recommendation. Is it because he’ll sell you high cost commission loaded funds in the IRA and make more money for himself? Or is it because you’ll have lower cost options in the IRA and a better investment plan?

Mistake #4: Getting dinged with penalties

Usually if you withdraw money from an IRA before age 59.5, you’l have to pay taxes on the withdrawal plus an additional 10% early withdrawal penalty (with some exceptions). A little known rule you may not know is that if you leave your employer after age 55, the 10% withdrawal penalty does not apply to 401k accounts. So let’s say you are age 56 right now and you leave your employer. If you keep your old 401k where it is, you can withdraw money from it now and pay the tax but avoid the 10% penalty. Realize that it’s the age at which you separate from the employer that makes this work. If instead you rollover your old 401k to an IRA, and you withdraw money from the IRA at age 56, you will have to pay the 10% penalty. This is important because if you’re thinking of early retirement, leaving the money in your old 401k might be the way to go.

Mistake #5: Gambling with your money

It’s tempting to rollover your old 401k to an IRA with almost unlimited investment choices. But what if you start buying penny stocks and lose everything? The chance of getting burned goes way up if you don’t know how to manage a portfolio. In this case it might be better to keep the old 401k even if that plan has poor investment choices. I’d rather pay high fees in the old 401k and at least get some diversification then to pay no fees in my IRA because my balance went to $0.

As you can see the decision to rollover of your old 401k -- like many financial decisions -- is multifactorial and depends your specific situation. Make sure you consider all pros and cons before signing off on the paperwork.