Today, Rick Bloom talks about 401k plans and the many options that are available to you when you exit a job - either willingly or unwillingly.
We start with general concepts around 401k plans - what it means to be vested, the ability to take loans against the plan, and what that can mean for tax implications.
Rick also touches on company stock and Roth 401k plans.
Essentially, there are four options for 401k plans, and Rick walks us through the positives and negatives of each one. They are:
As always Rick answers listener emails. Today's questions include:
As always, if you have a question for Rick, you can email him at:
Find Bloom Asset Management on the web at http://www.bloomassetmanagement.com/
Hello and welcome. I'm Rick Bloom and this is Rick Bloom Talks Money. I'm Rick Bloom, I’m an attorney, certified public accountant and financial advisor. The goal of our podcast is real simple –to make sure you make better decisions with your money because I believe money looks better in your pocket than it does anywhere else.
Independent financial advice. That's what you're going to get from this podcast at all times. I want to remind you about our email address, Rick@rickbloomtalksmoney.com. At the end of every podcast, we're going to take some of your questions like we will today. In addition, if you have any comments on our podcast, how I can improve it, we definitely want to hear from you.
Today's podcast is about 401k plans. And I can't stress enough how important it is that you handle your 401k plan correctly and particularly, when you leave your company. There are all sorts of tax issues involved and it's important that you make the right decision. And so that's what we're going to be talking about -- when you leave your company, what you should be doing with your 401k plan.
Before I get to what your options are, I want to go through some of the general concepts regarding 401ks that are important. And the first one deals with vesting. Money gets into your 401k plan a couple of different ways.1) It's your money that you're contributing into the plan and; 2) is when your employer contributes money. Your money is always 100 percent vested. What that means, it's your money; you can do with it what you want. If you leave the company, you can take it with you. The employer's contribution is a little different. Your ownership interest is the percent you are vested. For example, if you're in a plan that you are 50% vested and your employer portion of that is $50,000; if you leave the company, you can only take $25,000 with you. The other $25,000 is forfeited. So it is important to know what vesting is particularly, since every plan is a little different. There are all sorts of different vesting schedules. But typically if you're with a company for five years or more, you are a hundred percent vested, which means when you leave the company, you can take it with you.
Another of these concepts is loans. Now let me tell you right off the bat, I'm not a big fan of taking loans from 401k plans, but many people do. When your employment ends, the terms of your loan also change. Your loan becomes due the year the tax return for the year that you are let go is due. So for example, if you had an outstanding loan from your 401k plan that you took out last year, and this May, May 2020 you lost your job, you have to repay your loan by April 15, 2021. Or, if you file for an extension, it has to be repaid back by October 15, 2021. And it's important because if you don't repay your loan, there are tax consequences. The tax consequences are when you don't repay your loan, it's treated as a distribution, which means it's taxed at your ordinary income tax bracket. And if you're under 59½, you're going to also have to pay the 10% penalty.
Another concept that's important to understand about 401ks and that is if you have company stock. If you have stock in the company you were working for, and that company is a publicly held company, there are special tax treatments when you leave the company. If the price of your stock has significantly appreciated since it was contributed into your 401k plan, there's things that you can do to lower your taxes and also potentially lower your taxes to your beneficiaries. So it's important that if you have company stock that has appreciated in value, you look at the rules regarding net unrealized appreciation. And we're not talking about saving a few hundred dollars in taxes. Literally, we're talking about saving thousands and thousands of dollars on taxes. So if you have company stock, make sure you look at the rules regarding net unrealized appreciation.
Roth 401k plans -- Everyone knows that Roth 401ks like Roth IRAs are tax free. However, it's important to remember that in a Roth 401k money is still subject to minimum required distributions. Which means at the age of 72, even though it's a Roth, you have to start withdrawing from a Roth 401k. You don't have to from a Roth IRA, but from a Roth 401k, minimum required distributions at 72 are required. And also if you're in a Roth 401k, and you're in there for less than five years, there is some adverse tax consequences if you withdraw the money out of the plan.
And the last concept I want to explain is that if you have a small 401k, typically $5,000 or less, and you leave the company, most likely the company's going to give you no options; they're just going to write you a check for your 401k money. The problem with that is because of the law they must withhold 20% for federal taxes. So if you had $4,500 in a traditional 401k and you withdraw money and it's $5,000 or less, they're going to withhold 20% for federal taxes.
When you're leaving a company, whether it's voluntary or involuntary, you have four basic options when it comes to your 401k. You can keep it where it is, can move to your new employer, you can cash it out, or you can transfer it into an IRA. And I want to go through each one of those options and explain the pros and cons to you.
So the first one, you can keep your money within your old 401k. And by far, that is the easiest way to go. You don't have to do anything. There's no paperwork, you don't have to pick new funds, you can just let go as is. I've always been a believer in the KISS principle: keep it simple, stupid. It's what I say to myself all the time. Keeping money in the 401k plan of your old employer; it is simple. So it does keep things simple. However, there are also some downsides that it's important to understand. 1) Like unfortunately too many 401k plans, your old 401k plan may not have very good investment options. 401k plans are notorious for having poor investment options and companies never change them. 2) Some of the options within 401k plans are very expensive. Some 401k plans have two, three, even four percent unnecessary fees. Fees and costs matter. Therefore, before you would keep your money in your old employer's 401k plan you want to know all the costs that you incur and in too many of these 401k plans costs are ridiculous. Also keep in mind that plans may change. We've seen that had a lot from people who work in the auto industry, Ford, General Motors constantly change their 401k plans. So that's one of the downsides your 401k plan may change. In addition, another of the cons is the fact that in 401k plans, you have limited withdrawal options and in addition, because you would not be an employee, you can no longer borrow from your 401k and you can't add any new money.
On the whole, to me when someone leaves their company, they shouldn't leave anything behind. So in most cases I don’t recommend you leave your 401k at your old employer.
Another option that you have, you can move your 401k into your new employer's 401k plan, presumably that you have a new job and that new plan allows you to transfer money in. Most do, but many do not so it's important that if you're looking at this option, you talk to your new employer to see if you could add new money. The advantage of this is that your money could continue to grow on a tax deferred basis. You can continue to add new money into this account. It makes things simpler because you can consolidate your 401k.One of the problems with people moving jobs all the time, some people have three or four old 401k plans and it just gets difficult to manage it. When you consolidate things get easier. Also, you may be the lucky one where your new 401k plan may have some very good investment options and it also could be very low cost, and that's a benefit.
Another benefit of transferring the money is that you can take a loan against that money. And in addition, you also may be able to delay your distribution at 72 if you're still working. There is a provision in our tax law that if you're still working, you don't have to take your minimum required distribution out of your current 401k plan. You can delay it. That's not true with IRAs and it's not true with old 401k plans; only the 401k plan while you're still working at that employer.
The downsides of moving the money into your new employer is 1) you're going to have limited investment options. 401k plans aren't like they were in the past where you had unlimited options. They're very limited and it may not be very good options. Also, you can never forget about expenses. Expenses do matter. And one of the trends that we've seen recently is a lot of employers switch the costs of the expenses to the employee, so it's important you understand that. In addition, like I mentioned with leaving your plan at the old company, plans can change, and you also have limited investment options.
The third option that you have, and it's probably the most popular option in America and probably the one that I like the least, and that is to cash it out. In fact, nearly half of Americans, that's what they do with their 401k plan, they just cash it out. Now there's positives of that. It's your money and now you can do with it what you want. If you have high interest rate charge cards, you can use that money to pay down debt. You can take a vacation. Vvirtually you can do whatever never you want, and that's one of the benefits. The downside is that money is taxed to you. And it's taxed when you cash it out in one lump sum. So it gets added to your ordinary income. And in addition, you're going to have to pay a 10% penalty if you're under 59½. If it's a Roth 401k plan, you can lose some of the tax-free benefits if you take cash and close out the entire account within five years.
And another thing, and I think this sometimes doesn't get publicized, but it's important, lost opportunity cost. The fact is this is your retirement money and retirement money should be sacred. And if you cash it out and use it for other purposes, you’re losing out on that lost opportunity costs.
On the whole, for most people I'm not a big fan of cashing out your 401k plan. Because I think what generally happens is people end up putting into their checking account, they put it in their savings account and the money eventually evaporates. And that's not something that you want to do.
The fourth option that you have when you leave your employer with the 401k plan is to transfer it to an IRA. This is the option that I generally recommend to people and I think it's the one that gives you the most flexibility. And the reason for that is 1) The benefit of going into an IRA is that money can continue to grow on a tax deferred basis. 2) You could consolidate with your other IRAs, which again makes managing your money easier. I see this all the time, people have 10 IRA accounts, they have a few thousand here, a few thousand there. It makes it very difficult to manage. When you consolidate things are much easier. When you go into an IRA with your 401k money, you virtually have unlimited investment options. If you go into companies like Vanguard, Fidelity, and Schwab you’ll have thousands and thousands of investment options. And then you could focus on the ones that fit your situation and the options that have low costs.
Another advantage is you're going to have a better asset allocation because you're going to have more opportunity to go in different types of investments. I also think a benefit of going into the IRA is flexibility in moving money around and making withdrawals. Usually, 401k plans have all sorts of restrictions about withdrawing money. In an IRA you virtually can do what you want. You could take a distribution every month of the year if you choose. You can't do that with a 401k. Also, with an IRA, there are ways you can withdraw money penalty free before 59½, for education and also for first time home buyers.
In addition, one of the benefits of an IRA is that it's easy to convert it into a Roth IRA. I can't tell you how important it is to take advantage of different opportunities and one of them is Roth IRAs because Roth IRAs grow on a tax-free basis, not tax deferred. And in addition, Roth, IRAs are not subject to minimum required distributions at 72. It is very difficult to convert a 401k into a Roth, but it's very easy to convert a traditional IRA into a Roth IRA.
Although there are much more benefits to transferring the money into an IRA, there are also some downsides and one of them is that once money is in an IRA, you can't borrow. There is no borrowing against an IRA. 2) When you take money and you roll it over into an IRA from your old company, for some reason the sleaze in our society start contacting you. They get notices and so you're going to start getting calls from salespeople who all they want to do is sell you something. And so many of their products are stuffed with high fees and ridiculous commissions. So it is a downside that you may have to put up with the salespeople, but I say it's very easy. Don't take their call, hang up on them. It's much easier that way.
Another downside is because there are so many options, sometimes we get paralyzed by analysis. People want to look at every investment. You cannot do that. And so it's one of the downsides that you have so many options, but you have to limit the ones. And that's why I always say, I always focus on commission-free funds; it limits the amount of work I have to do in selecting the right fund.
Another of the downsides of moving money into an IRA is that you are required to take required minimum distributions at 72. Even if you're still working, you still have to take a minimum required distribution at 72.
And another downside, it doesn't apply to everyone, but it does apply in many situations, is that in some states there are more creditor protections in a 401k plan than there is in an IRA. So if someone was at risk of being sued, you're in the type of profession that there's a greater risk; in certain states you'd want to keep it in a 401k versus an IRA, just so you can have a little better protection.
The four options that I mentioned, you can either leave it at your former employer, you can cash it out, you can transfer it to your new employer or move it into an IRA. Those are the four options you have to consider. The key if you're moving it into an IRA, and that's the option I recommend for the great majority of people, it should be your default option; the key is to make sure you have the money directly transferred from the old 401k into the new 401k. By directly transferring the money there are no tax consequences and that's one of the keys and it's a very simple transaction. If the old company issues you a check, they're going to have to withhold 20%. Then you'll have 60 days to take that money and roll it over into the IRA. However, you do create a problem. So let's say you had $100,000 in your IRA and they give you a check. The check's not going to be for $100,000. They're going to have to withhold 20% or $20,000 for federal taxes. So your net check is $80,000. So if you roll the money in to an IRA, you don't pay tax on that $80,000. You're still going to have to pay tax on the $20,000, unless you replace that. And in addition, that $20,000 you can be subject to the 10% penalty. So the key is, is to make sure the money gets directly transferred.And if for some reason the company issues you a check, a lot of times you can go back to the company and have them cancel that check and work on the direct transfer. It is a much easier way of going.
When you look at your options always remember this, you don't have to decide anything tomorrow.You can take your time.
In the past one of the downsides was if you had it outstanding loan, that loan was due within 60 days of when you lost your employment. And therefore, people had to make tougher decisions. That is no longer the case today. In today's world with new law changes, you have a much greater length of time to make your decision. So my advice--don't let anyone talk you into anything. Do what makes sense for you. And I would tell you for the great majority of people rolling the money and directly transferred it into an IRA is the one option that's going to give you the greatest flexibility and it's going to allow you to be totally in control of your money. And I'm a believer you should be in total control of your money, because when you're in control, you're going to have better investment options and lower cost investment options. And when you have lower cost investment options and better investments, that means more money ends up in your pocket. And as far as I'm concerned, that's exactly where it belongs.
What I want to do now is to shift gears and get some of your questions. So the first one comes from Ed in West Bloomfield.
Q. Lots of major companies have high PE ratios because earnings are down, but it doesn't appear to be affecting stock market buying. Are we looking at another bubble bust like the dot-com market back in 2008?
A. Well, first of all, Ed, the dot-com crash actually came back in 2000. That's when we had really the dot com crash. There's a couple things; first of all, I do believe that PE ratios are high right now. But PE ratios are just one way that you can value a company. There's a lot of different metrics that people use to value a company. And in addition, when we have low interest rates, which we have now, it does affect value. But that being said, what I believe is happening, I believe investors, Ed, they're writing off 2020. It's like 2020 is over with and they are more looking at 2021. And I think that's the thing to look at. That's what the market is. Now, do I see a bubble? It doesn't appear to me that we're in a bubble right now. If you go back to 2000, we had this crazy market that all you had to do is put dot-com next to a company and that company went through the roof. There were no fundamentals, these companies weren't producing anything, they weren't making any money. That's a lot different than we have today. Companies are still making money and companies are producing things. So I don't think it's the same type of bubble or that we're in a bubble like we were back in 2000 or back when you go to 2008, the bubble was mostly in real estate. So I don't see a bubble happening at this point time. But I do agree with you, it is sort of irrational why the market is going up so much. And again, I've always told people the market is irrational over the short term, it makes much more sense over the long run.
Next question is from Amanda, from Chicago.
Q. What impact does party Republican or Democrat really have on the economy?
A. Amanda, that's a great question. I'll tell you, I've looked at how markets have performed whether it's been Democratic or Republican administrations, and on the whole, markets are pretty much the same. So I think in general whether it's the Democrats or the Republicans markets are going to perform pretty close to the same.
Now one thing markets do not like is markets do not like uncertainty. So if there is uncertainty, that's going to cause some problems in the market. And the other thing is if the Democrats right now control the House and Senate and there is let's say more of a push from the progressive side of their party, that is going to cause taxes to rise faster and that could have a negative impact. I don't think it will be a long-term impact, but I do believe that will have a negative impact. But I would tell you always to keep this in mind -- what politicians say during their campaign and what they do in real life is generally two different things. I always tell people, I never believe what politicians say during the campaign, because they'll say anything. You have to look at what they do. So if people are asking me, Rick, am I selling out if I think that Joe Biden's going to win the presidency? Absolutely not because the U.S. economy is much more resilient than looking at party affiliation. So I'm not making any changes in the portfolios I manage based upon the presidential election. And elections do have consequences and there will be consequences, but markets adjust. And I'll go back to when President Obama won the election; there was a lot of talk that the markets were going to crash and we'd have at least another four years of down markets and it didn't happen. And so I would tell you, Amanda, I wouldn't focus on whether it's the Democrats, the Republicans. I think the real focus should be on your goals and objectives and what you're trying to achieve. I tell investors all the time, don't focus on the market day to day, because what happens in the market day to day is relatively immaterial to you and me. It's fun to watch, it's entertaining, but in reality, it doesn't really mean much.We have to focus on the long-term, let the market gyrate day to day; we need to focus on the long run.
One last question from Mary.
Q. Mary asked me if this is a good time to refinance. My current mortgage is at 6%. What do you think?
A. Mary, I think this is a great time to refinance.If you're at a 6% mortgage you may be able to reduce that mortgage in half to about 3%. In fact, for the first time in history 30-year fixed rate mortgages fell below 3%. So there are lots of opportunities to refinance and what I would tell you -- a couple things, 1) Shop around, receive competitive bids. Don't assume all mortgage companies are the same because they're not. 2) You have to focus on cost; cost do matter, particularly when it comes to refinancing. And it's a fair question. What I always want to do when I refinance, I want to find out what is the out-the-door cost. Mortgage companies are great at coming up with different types of fees and they call them all sorts of different things. You know what, in the long run, I really don't care what they call it. It's money coming out of my pocket. That's what I care about. So when you shop for a mortgage, not only should you shop rates, but you need to look at the total cost --what your out of pocket cost is before you get that mortgage.Also, don't be afraid to negotiate.You can negotiate some costs away. I know people sometimes are afraid to negotiate. The worst they can tell you is no. And trust me when you start shopping around and you get competitive bids, you're going to see companies that will be very happy to lower their costs to get you as a customer. So this is a great time to refinance, rates are low, take advantage of it.
Now, one last thing Mary; and Mary mentioned in her note to me that she had a 30-year mortgage with about 25 years left. You don't have to refinance under another 30-year mortgage. You could refinance under 25 years. You may be able to make the same payment you're making now and cut off years off your mortgage, so that's the way that I would do it, Mary.
I'm looking at the clock and we're just about out of time. I want to thank you for the company. I enjoyed it. Hope you did as well. Want to remind you about our email address? Rick@rickbloomtalksmoney.com. At the end of every one of our podcasts, we're going to take your questions. So if you have any questions, any comments on the podcast, I'd love to hear from you.
Have a wonderful week, take care, and thanks for joining me. Bye now.