Advanced Personal Finance

There has been lots written about what to do with a 401(k) when you leave a job and why.  I’m not going to rewrite those posts.  Instead, what I do want to talk about is my experience rolling a 401(k) over into an IRA.  I’ll show you how to do it and pitfalls to avoid.

When you leave an employer in whose 401(k) plan you participated, you have some decisions to make regarding your retirement savings.  Really, your options are three:

• Leave the money in your old employer’s plan
• Roll your account into the new employer’s plan (if allowed)
• Rollover into an IRA

I recently left my job and chose the third option - a 401(k) to IRA rollover.  It had been many years since I did this last and I’d forgotten how it goes, so I thought I’d review it here.

Step 1: Decide where to open the IRA

There are several advantages to rolling a 401(k) into an IRA.  Two of the biggest are investment options expand dramatically (for good or bad) in an IRA and the opportunity to save money on fees.

401(k)s are inherently limiting.  You’re limited in what you can invest in (that is, only what your employer offers).  You also can’t take your business elsewhere if a 401(k) plan gouges you on fees.  A rollover to an IRA gives you an opportunity to fix these problems.

When evaluating where to open your rollover IRA, you want to look at those two elements - investments offered and fees charged.  In this case, bigger is better.  You want to go with a large fund family or brokerage.  Vanguard, Fidelity, and T. Rowe Price come immediately to mind.  Generally, they charge very low fees on their products.  They also give you lots of different investment options from which to choose.

But I didn’t use any of these three.  I used USAA because they are my all-purpose financial provider.  I’ve written before about their awesome service and I like having all my accounts consolidated in one place.

Step 2: Contact your choice and set up accounts, if necessary

After I decided to go with USAA for my rollover, I gave them a call.  I already had retirement accounts of various types open with them.  I wanted to prepare the ground for the rollover, though.  I called USAA and had them open two new accounts - a Roth rollover account (since some of my 401(k) is the Roth type) and a money market account for the traditional IRA.  Why money market?  I want to rebalance everything once it’s consolidated, so this gives me the opportunity to do that.

Step 3: Call the administrator for your old plan

I then called the administrator of my old employer’s plan - Fidelity.  They were excellent.  They actually have a group of people assigned to assist people after they’ve left my old company.  Naturally, they’re there to also try to get you to leave the money with Fidelity, but I did not get a hard sell.

I have a bit of a complicated situation in that I have traditional 401(k) contributions, Roth 401(k) contributions and after tax contributions.

There’s a big difference between an IRA rollover and a 401(k) rollover.  In an IRA to IRA rollover, you never see the money.  It goes electronically from one investment firm to another.  Not so with a 401(k) rollover.  In that case, the checks have to be sent to you (”For the benefit of [the investment firm]” is written on the checks) and you send them to the investment firm.

I think this is a stupid set-up for a couple of reasons.  First, seeing a (hopefully) large dollar figure on a check makes people question rolling it over.  I think it might encourage 401(k) withdrawals.  Secondly, there’s a (admittedly small) chance the checks might be lost in transit or be deposited incorrectly.  Finally, if you’re not careful and forget about it, you might take a withdrawal inadvertently.

Anyway, I recently got the checks in the mail and now have to close the loop and send the checks to USAA.  At that point, the 401(k) to IRA rollover will be complete.  Then it’s time for a complete review of my asset allocation.

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This was a new one to me.  I learned another weird IRS rule today.  This one was about 401(k) rollovers and after-tax contributions.

A couple of months ago, I changed jobs.  Today I called the my old employer’s 401(k) plan administrator, Fidelity.  The man assigned to help me with the disposition of my 401(k) was very helpful, especially with my somewhat complicated situation.

My now-former employer allowed Roth 401(k) contributions beginning last year and I took advantage of the opportunity.  (Incidentally, I highly recommend taking advantage of the Roth 401(k) if you’re offered it.)  Several years ago, I screwed up at the end of the year and didn’t shut off my 401(k) contribution in time.  I hit the limit for that year but money kept coming out of my paycheck and was contributed after tax.

So I had three sources of funds for the rollover: 

• Traditional before-tax
• After-tax Roth
• After-tax non-Roth. 

So this wasn’t a straightforward rollover.  The guy helping me actually had to get help from another guy who knew the rules a little better.

Here’s where the weird IRS rule comes in.  If your (joint) AGI is below $100,000, you can have the after-tax non-Roth funds rolled over as a current year Roth IRA contribution.

Our income this year is slightly over that amount, so the rule is I can’t have a check made out to USAA (the place I’m having the money from Fidelity sent to) directly as a 2008 Roth IRA contribution.  What I have to do is have the check made out to me and then send it to USAA.

In fact, I could do whatever I want with the money since I’ve already paid taxes on it, but using it toward this year’s Roth IRA sounded like a good idea.  Trouble is I can’t do that in one easy step. 

Like I said, weird rule.

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Tired of the same old 401(k)?  How about a Super 401(k)?

Some companies have started offering a new defined contribution retirement plan to employees.  Here’s how it works.  In return to ceding control over how your contributions get invested, you gain a turbocharged contribution from your employer.  As this article from Business Week points out, these plans are hybrid of a traditional 401(k) and a pension.

And the increased employer contributions can be substantial - think 15% to 20% of your yearly salary.  That’s in addition to the more standard 6% match on your contributions.

So what’s not to love?  Well, like the man says, there’s no such thing as a free lunch.  In return for the increased match, you turn over control of how the plan (and your money) is invested.  Typically, the employer will select a so-called lifestyle or target date fund.  Such a fund matches your projected retirement date to an appropriate asset allocation.  I personally like target date funds and recommend them to people without much interest in investing.  In this case, you’d be turning over control of the investment, but it would like be invested how you would have done it anyway.

That isn’t so bad until you consider the down side of the equation.  If how the employer invests the money isn’t so smart and you don’t have enough to retire at your projected retirement age, tough luck.  You keep working.

I’m not so sure you’ll see a lot of this in the future.  I don’t think turning over control of their money would appeal to a great many people.  Besides that, there’s the legal risk.  You can sign all the papers you want, but if your company takes your retirement money and invests it inappropriately, I tend to think you’d have legal recourse.

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Something I just can’t figure out about some companies’ benefits - 401(k) waiting periods. Why in the world would a company limit how soon you can start participating in their 401(k) plan? It goes totally against the current movement toward automatic enrollment, yet some places it persists.

Why? The party line

I had occasion recently to take a look at the benefits package of a medium-size company that had a waiting period on their 401(k). When I did a little research, I could only find a couple of pretty weak reasons for a waiting period.

• 401(k) administration costs money, so a company wants to make sure you’ll stick around before incurring start-up costs. This doesn’t make sense to me for two reasons. First, these ‘administrative costs’ are tiny for each additional person in the plan. Second, how does waiting three months or six months overcome this objection?
• Means testing puts limits on contribution levels for participants if there are enough non-participants. I guess companies that have waiting periods figure you’ll start out as a non-participant and lower their means testing ceiling. Again, though, this doesn’t really make sense as the principal of inertia says people who have to take action to make a change tend not to do so. If you’re prevented from participating, even temporarily, in a 401(k) plan, your chances of never participating are much higher. By the time the six month waiting period expires, you’ve gotten used to your full paycheck and likely will have forgotten all about retirement savings. Dumb.

Regardless of the reason, 401(k) waiting periods exist at a shockingly high number of companies. The data I could find says a third of companies have a waiting period and a quarter have a one year waiting period! Simply amazing.

How to overcome a waiting period

If you do take a position at a company with a 401(k) waiting period, there are a couple of strategies you can employ so you don’t lose too much ground saving for retirement.

• Use an IRA as a substitute. You can use an IRA as a low-rent substitute for a 401(k) in a pinch. You have two choices - deductible (or ‘traditional IRA’) and Roth. In general, I think the Roth is the better deal, but it has no current-tax-reducing qualities, so if you’re looking to reduce your taxes this year, the traditional IRA might be for you.
• Save outside a traditional retirement plan. Once you’ve maxed your IRA for the year, you can start saving in a taxable investment account. This isn’t really such a bad idea, because you can use such an account for anything, not just retirement, so if something else comes up, the money’s there.
• Negotiate with the employer. This might seem far-fetched, but after a hiring manager knows he or she wants you, you have a bit of leverage. Traditionally, people just ask for more money. If the 401(k) is important enough to you, and you’re important enough to them, there may be room to move.
• Save outside the plan then save twice as much once you’re in the plan. Start saving in a savings account from day one of employment. Then once you’re eligible, make your contribution twice as much as you normally would and live off part of the savings account each month to fill in the gap in your monthly budget.
• Be more aggressive. Once you’re eligible to save in the 401(k), you can be a bit more aggressive with your asset allocation than you normally would, at least for a little while. This strategy isn’t without risk like the others are, though, so consider it carefully. Besides, being more aggressive is easy to say and hard to do sometimes.

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In an earlier post, I mentioned some of the changes to 401(k)s in 2008. One of them was automatic enrollment. In that post I also mentioned that the IRS still had to rule on what those automatic contributions should be invested in. To that end, a couple of weeks ago the IRS promulgated its guidelines on how employers can invest the contributions of people automatically enrolled in their 401(k) plans.

Here are the investments the man says are copasetic:

1. A product with a mix of investments that takes into account the individual’s age or retirement date (e.g. a ‘lifestyle’ or ‘target date’ fund)
2. An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (e.g. the invest advisor or plan administrator’s version of a lifestyle fund)
3. A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (e.g. a generic ‘balanced’ fund)
4. A temporary capital preservation product for only the first 120 days of participation (e.g. a money market fund). The idea on this is that if somebody subsequently opts out, the 401(k) hasn’t lost their money due to a market decline.

There you have it. If you get automatically enrolled in your company’s 401(k) or equivalent, your money has to get dumped into one of these products.

My take is that this pretty smart. I recommend most lifestyle funds to investing novices. Since the first two options are exactly that, and the third is pretty much that, I like how the IRS did this.

I hope employers offer some education on investing to go along with automatic enrollment. Since companies have transferred all of the responsibility for funding and managing your retirement, it’s only fair they smooth the transition with that kind of information.

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