Ric Lager, president of Lager & Company, which advises 401(k) plan participants, Golden Valley, Minnesota. He is author of Forget the Pie: Recipe for a Healthier 401(k). LagerCo.com
If you are among the 90 million Americans who invest in a 401(k) retirement plan, you might be surprised by the big opportunities you are missing and the costly mistakes you are making in how you handle that account.
Here are some of the most surprising things you should know about your 401(k)—or a similar 403(b)—whether you have it at a current employer…still hold one from a former employer…are considering shifting it to an IRA…or will be taking distributions soon.
Employees often pay much less attention to the assets they have in their employer-sponsored 401(k) accounts than to the assets they have in IRAs or taxable accounts. In many cases, they think they can rely on the employer to keep them from making big mistakes. That leaves them open to various surprises.
• Surprise: Your funds could be switched. Your employer or 401(k) administrator can drop a fund that you are in and shift your assets to a different fund it chooses. This may happen when a lower-cost fund becomes available…as a way to make the investment menu more attractive by replacing a fund that has done poorly over the past year with one that has done well over that period…or because the management of a fund or the administrator of your 401(k) plan has changed. You typically are notified by mail and/or e-mail at least 30 to 90 days before this switch, known as “mapping,” takes effect, but the notifications are easy to overlook.
What to do: Check the new fund’s five- and 10-year record rather than just the one-year record, and consider whether there is another fund available that is more attractive.
• Surprise: You’re in the wrong target-date fund. A target-date fund—a very popular type of fund in 401(k)s—is designed to shift its mix of investments to reduce risk as the fund’s target year gets nearer. Even though it is common for an employee to choose the version of the fund whose target year coincides with his/her planned retirement year, that is not always wise.
For instance, you might end up working several years longer than you expected. Or you might have other sources of substantial income—ranging from a pension and Social Security to money-market accounts and certificates of deposit (CDs)—that you can draw on before you tap the target-date fund. If so, you may want to choose a target-date fund with a later target year (which means that it is weighted more toward stocks).
It might make sense to keep your money in a 401(k) even after you have stopped working for the employer that sponsors it rather than roll it over to an IRA.
• Surprise: Once you have left the employer, you could withdraw assets from the 401(k) without penalty if you are at least 55 years old—you could not do this until 59½ with an IRA. A twist: If this possibility seems enticing and you still are working for the employer that sponsors the 401(k), you might want to think ahead and do a “reverse rollover”—moving assets from a traditional IRA into your current employer’s 401(k). That could increase the amount available to withdraw from the 401(k) after you leave your current employer. About two-thirds of 401(k) plans allow these reverse rollovers.
About 60% of all 401(k) participants transfer or “roll over” their accounts into an IRA when they leave a company or retire, but they should first consider some surprising advantages and disadvantages. (For more, see our article at BottomLineInc.com/job401k.)
• Surprise: In some cases, you can invest in mutual funds that are closed to new investors if you roll over your 401(k) to an IRA. Example: At T. Rowe Price, you can gain access to any fund that is closed to new investors, including highly ranked funds such as Capital Appreciation, Mid-Cap Value and New Horizons. Caveat: The fund can’t be completely closed—it still must be accepting additional assets from investors who have already invested in it.
• Surprise: If you are rolling over a 401(k) to an IRA, in some cases—but not all—you must liquidate your mutual funds and then transfer the cash to the IRA, where you can reinvest it. This is always true if you are rolling over the 401(k) from one investment firm to a different one, even if the same mutual funds are available in the IRA at the second firm. And it usually is true even if you are staying within the same investment firm for any funds that are not managed by that investment firm. Examples: If you have a Fidelity fund in a 401(k) that is administered by Vanguard and you want to roll it over to an IRA at Vanguard, you must cash it out first, repurchase the shares at Vanguard and typically pay Vanguard a transaction fee. You also would have to sell your shares if your 401(k) account includes one of the “institutional” class Vanguard funds, which charge extremely low fees, because that class is not available in IRAs. You then could purchase the same fund in a class with higher expenses (but no transaction fee).
What to do: Before rolling over a 401(k) to an IRA, check with the company that will hold your IRA to determine all of the fees and ongoing expenses that will be involved, and take this into account when deciding which funds to choose.
Many investors assume that the IRS requires them to take required minimum distributions (RMDs) from their 401(k)s starting at age 70½ because they must do that for their IRAs.
• Surprise: The rules regarding RMDs are different for 401(k)s and IRAs. For instance, if you still are working at age 70½, the IRS does not require you to take RMDs from your current employer’s 401(k) until you retire or leave the company. For both 401(k)s and IRAs, the amount you take is based on a life-expectancy formula that is calculated each year and on the value of your accounts. But for 401(k)s, you must calculate the RMD formula separately for each 401(k) requiring an RMD and take the appropriate amount from each.
In contrast, for IRAs, you apply the formula to the total amount in all your IRAs—whether you are employed or not—and then you get to choose which IRA or combination of IRAs the distribution comes from. Keep this in mind when deciding whether and when to roll over a 401(k) into an IRA.