What Do I Do With My 401(k) When I Leave My Job?

The average millennial changes jobs four times before they reach the age of 32.  Generally speaking, this is a great thing from a financial perspective- salary tends to go up whenever you change jobs.

There are a few situations that can arise when we hop from job to job, though.  For example, what should you do with your 401(k) once you leave a job behind?  Too often, this step gets lost in the shuffle, and it can be easy to lose track of these accounts if you aren’t careful.  So, what should you do with your employer-sponsored retirement account once you leave?

Four Options

There are typically four options that you can pursue.  There’s no universal right or wrong answer here (although one option is significantly worse than the others). But, the most important thing is to develop a system to keep track of these accounts as you move from job to job.  I have a dedicated framework that can help with this- and I’m sharing it for free on my webinar on March 7.  The bottom line- whatever you do, make sure you are able to keep track of where all of your retirement accounts are!

With that being said, let’s discuss the four options in detail.

The Two Not-So-Good Options

Your first option is to cash out your 401(k).  As in, when you leave your current job, you technically can withdraw all of the money from your 401(k) to spend it today.

That being said, this is generally a terrible idea.  Retirement accounts should be kept until you’re ready to, you know, retire.  And, you’ll pay a hefty tax penalty by cashing out of your 401(k) early.  Just because it’s technically one of your four options, doesn’t mean you should actually do it.

Your second option is to leave it with your old employer.  There are some employers that force you to move it to an IRA if it’s a small account, but in most cases you can leave your old 401(k) with your old job.

That being said, there are a few reasons I typically don’t recommend this approach:

  • This is probably the easiest way to lose track of your account. If you leave all of your 401(k)s at old jobs, it can become difficult to monitor all of them.  And, of course, you really should be keeping an eye on your investments over time and adjusting them as you get closer to retirement.  As you have more and more 401(k)s, it can be harder to keep tabs on all of your different investments if they are scattered across account with your old employers.
  • Typically, employers charge fees on 401(k)s for people who are no longer employed with their company. Why pay that fee, that you aren’t getting any service for, if you don’t have to?

If your old 401(k) has great, low cost investments, it might not be a bad idea to keep your account there, but that generally is the only time I recommend this.

The Two Better Options

Two options down, two to go.  And luckily, these options are typically better.

Your third option is to consolidate your old 401(k) into your new one, if your new employer will let you.  The idea here is simple- why have two accounts to keep track of when you could combine them all into one account?  Moving your old 401(k) balance into your new job’s 401(k) is a great way to streamline your accounts.

This doubly goes if the fund options in your new 401(k) are good ones.  If you have good investment options that have low fees associated with them in your new 401(k), combining the two accounts is a no brainer.  You’ll be limited to the funds available in your company’s plan, but if they’re good, that might not matter too much.

Unfortunately, many 401(k)s use high fee accounts that can really eat into your retirement returns over time, and you aren’t getting anything in return for the fee you’re paying.  Which leads us to option four:

You can move your 401(k) into an IRA.  To do this, you’ll need to open up a brand-new IRA for yourself (unless you have one already, of course), and then request your former employer to transfer the balance to your new IRA.  You’ll then need to select the investments you’ll want to use in your IRA, and monitor their performance over time.

A few notes here:

  • When you request your old employer to move the funds to your IRA, make sure they know that you’re moving it to an IRA. Moving a 401(k) to an IRA is not taxable, but if they think you are just withdrawing your 401(k) to your bank account, you’ll need to pay a penalty to the IRS.  So, make sure they address the transfer to your IRA.
  • Make sure the account is a Traditional or Rollover IRA, not a Roth IRA. Transferring a 401(k) to a Roth IRA will cause you to be taxed on the entire balance of the account.  This can be beneficial for some people, but you definitely want to consult with a financial planner before you do this.  The key point- make sure that you don’t open up a Roth IRA by mistake!
  • One of the benefits of moving a 401(k) to an IRA is that you have full freedom over the investments in the account. You aren’t limited to a few funds in your 401(k), you can choose anything.  But, taking this approach means that you’ll need to screen your investments and rebalance your accounts over time.  I’d be happy to chat about this if you have any questions about how to do this.
How to Decide between Consolidating and Transferring to an IRA?

So, let’s take it for granted that you’re trying to decide between the last two options- combining your 401(k)s, or moving your old 401(k) to an IRA.  How should you go about making this decision?  A few key things to consider:

What are you Paying in Fees?- there are some great 401(k)s out there, but unfortunately, many of them aren’t so great.  Many 401(k) accounts only have a few funds to invest in, and they tend to have high fees associated with them.

Use a site like www.personalfund.com to evaluate how much you are paying for fees in your 401(k). If your new 401(k) has a lot of low fee options, it might make sense to combine.  If you have a lot of high fee options, it probably makes sense to go with the IRA.

Do you Need Help? Do you feel ok self-managing your investments, or do you want the help of a professional?  Most financial planners don’t provide direct investment advice on 401(k)s (although I do!), so if you want some help with your investments, usually you’ll need to move it to an IRA.  But keep in mind, that will come with an extra cost.

On the other hand, if you feel confident managing your investments yourself, you could pick either route.  It’s just a matter of which funds you’d like to invest in.  Speaking of which…

What Funds are Available?  As I’ve alluded to multiple times, 401(k)s typically provide some convenient funds to invest in, but they tend to be limited and higher in cost.  If you want a more extensive investment option, including stocks and index funds, you should probably move to an IRA.

There’s No Universally Right Answer

Ultimately, when you review the items listed above, you might find that you probably can’t go wrong between options 3 and 4.  It all comes down to personal preference, and how much you care about investment options and fees.  Ultimately, do your homework, and you should be able to sleep soundly with your decision.

And if you have further questions about retirement preparation, sign up for my webinar on March 7th to discuss these strategies in more detail!

 

How to Allocate Your Money Effectively

[Click here to register for my webinar, “How To Organize Your Finances and Create a Roadmap Toward Financial Freedom”!]

Ever since I founded Pacesetter Planning, I’ve worked with my clients on a wide range of financial topics.  I’ve gotten a variety of questions from clients and potential clients, and while everyone’s situation is a little different, generally they fall into the following categories:

  • How do I manage my finances with my husband/wife/fiance/significant other?
  • How much do I need to buy a house?
  • How much should I be saving for retirement?
  • How do I select investments?
  • Should I put extra money toward my student loans or should I direct that money elsewhere?

As you may have noticed, I’ve addressed a good number of these topics at a high level on this blog already (and will continue to do so).  But, you may have picked up on something else.

All of these Questions are Interconnected

It’s hard to make financial decisions in a vacuum.  Often times, the hard part isn’t answering these individual questions, but finding the right answer to them all at the same time.  It often isn’t practical to increase your saving for retirement and buy a house and pay extra on your student loans all at once.  These decisions need to be made together, and there’s usually not a clear right or wrong answer.

That, of course, is where I come in.  I help my clients develop plans to manage their finances, prioritize their goals, and help them allocate their money accordingly.  We set targets and track progress against these goals, updating as needed.

You Need a Framework to Make these Decisions

While everyone’s circumstances are a little bit different, I use a strict framework and process to help clients make these decisions.

And I’d like to share it with all of you.

On Tuesday, March 7 at 8 PM EST, I’ll be hosting a free webinar called “How to Organize Your Finances and Create A Roadmap Toward Financial Freedom”. You can register for the webinar here.

On this webinar, we’ll discuss:

  • How I recommend clients structure their accounts to keep track of their finances
  • How to implement a system to manage your income month to month to pay yourself first
  • How much money you’ll need to retire, and what it will take to get there
  • How to balance your everyday spending with your short and long term financial goals
We Face Greater Financial Challenges than our Parents and Grandparents.  Plan Accordingly.

Sometimes I get pushback when I say this, but I truly believe that millennials face much greater challenges than previous generations.  Think about it for a minute.

Most of our grandparents worked 40 years at the same job, retired and received a pension from their company to fund their retirement.  They have Social Security.  When they were our age and looking to buy a home, housing prices were about twice the average annual salary.

Many of our parents may have had multiple jobs over the course of their careers, but most of them only had one job at a time.  Some of them may still have a pension, but all will (barring some sort of catastrophe) receive Social Security.  And again, the average home price when they were in their twenties was around twice the average annual salary.

Now?  The average millennial changes jobs four times before turning 32. More than 1/3 of millennials have a side job.  The average price for a home has jumped to about 3.5x the average annual salary. Most of us have some type of student loans.

Pensions? Social Security?   ¯\_(ツ)_/¯

We have some big challenges ahead of us.  The good news is that these challenges can be beaten.  But, you need a method and a plan to get you there.  I’ve got it for you.

I Want to Teach You Everything I Know

I didn’t get into financial planning to only work with rich clients.  My goal is to help make all of my clients wealthy someday.  The more people I can help, the better.

Sign up for my upcoming webinar, and let me know if you have any questions you think I should address.  I look forward to sharing my methodology with you all.

How to Pick Investments in Your 401(k)

Stop me if you’ve heard this one before.

You get a new job, go in for your first day, excited to get started.  Six hours into an eight hour onboarding training, you get a packet from HR with a 40 page document about your 401(k).  And, for the most part, you’re essentially left to set it up on your own.

You dig a little deeper and set up a certain percentage of your paycheck to go into your 401(k) directly. Now, it’s time to select the funds in which to invest.  The million dollar question- where in the world to start?

I’ve seen plans have as many as 50 different funds options to choose from. And most plans give very little guidance on how to make your decision.  So, what do you do?

A Very, Very Brief Primer on Mutual Funds

This probably warrants its own separate post, but before we talk about how to choose a fund, it’s important to know what exactly you’re choosing.

The funds available in a 401(k) are mutual funds.  There are a wide variety of mutual funds, but the general idea is the same across the board.  If you put $10,000 in a mutual fund, the manager of the fund will invest it into a wide variety of stocks and bonds.  The fund manager then reallocates these investments over time according to the fund’s objectives.  When you wish to withdraw your money, you recieve your portion of the funds growth (or losses).

Mutual funds are a great way to diversify your money.  When you put your money into a mutual fund, you aren’t just buying a single company’s stock.  Generally, you’re putting your money into hundreds of stocks and bonds within a single fund.

Every mutual fund has a different objective, and risk level.  On one end of the spectrum, some funds only invest in smaller companies in Africa and Asia.  These are considered very high risk/high reward investments.  On the other end, some mutual funds only invest in US Government bonds. In turn, these are very low risk funds (that in turn, offer much less upside potential). Most funds are somewhere in between.

Your 401(k) Investments Should Be Fairly Aggressive Early in Your Career

There’s no right answer for exactly how much risk you should take with your investments.  The amount of risk you take generally depends on two things- how much risk you want to take, and how long your money will be invested.

This second piece is the key here.  Your time horizon for how long your money will be invested can sometimes override your risk preference.  For example, even if you are a very aggressive investor who wants to take a lot of risk,  it’s not a good idea to invest that money aggressively if you are planning on using your investments to buy a house in six months.  If the market were to crash, you might not have enough money to buy that house.

The flip side is also true.  If you’re investing for a long time, it probably makes sense to take more risk in your investments.

For millennials, the biggest risk to your retirement assets doesn’t have anything to do with the stock market at all.  The biggest risk is inflation.

To phrase it differently, inflation has averaged around 3% every year.  Meaning, that every year, the things you buy tend to get about 3% more expensive.  If your investments for retirement aren’t at least keeping up with inflation, you’re essentially losing money.  The investment risk for a retirement portfolio that averages 6-8% a year is well worth it. Particularly because a “less risky” portfolio averaging a 2-4% return could leave you with less money, inflation adjusted, than what you have today.

All of this is a long way of saying- if you’re in your 20s, you want to make sure you focus your investments on growth to maximize the portfolio’s value by the time you retire.  Swings in value in your 20s and 30s are a small price to pay to beat inflation over time.

…But As You Grow Older, Make Your Retirement Accounts More Conservative

Just because a growth-focused 401(k) portfolio is right for you now, doesn’t mean it always will be.  As you get older, shift some of your portfolio from stock funds to bond funds.

A good rule of thumb is to move 10% of your account from stocks to bonds every 10 years.  That way, by the time you retire, your portfolio is likely to have a good mix of growth and income-focused investments, varying slightly depending on how much risk you’re comfortable with.

So, How Should You Invest? You Have Two Major Options

With all that being said, what funds should you choose in your 401(k)?  While all plans offer different fund choices, you generally have two options:

  1. Retirement Target Date Funds

Almost all plans have retirement date target funds.  The name of these funds varies from institution to institution, but they generally contain “Retirement” or “Target Date” in the name, followed by a suggested retirement year.

If you decide to go this route, choose the fund that corresponds with your expected retirement date.  The target retirement dates are typically stated in five year increments.  For example, a 25-year-old expecting to retire in about 40 years might choose the “Retirement Target 2055”, since 2055 is about 40 years from the current year.

These funds can be a great option for one simple reason: simplicity.  All of the stuff I describe above about how your investments should start out focused on growth, and become more conservative over time?  Target date retirement funds do it all for you.

Target date retirement funds are designed to be, in theory, the only fund you “need” in your portfolio.  They are well diversified, automatically rebalance, and become more conservative over time.

The only problem?  They can be expensive.  All mutual funds have some sort of cost associated with them that come out of your account.  Typically, since target date retirement funds do this work for you, they can be much more expensive than other fund options in your portfolio. This could leave you with tens or even hundreds of thousands of dollars less when you retire.

I recommend doing a cost analysis of the different fund options in your portfolio using a site like www.personalfund.com.  Or, I’d be happy to conduct a 401(k) review to make sure you aren’t leaving money on the table.

  1. Build Your Own Portfolio

If you want more control, or lower fees, on your retirement accounts, you can build your own portfolio.  The great news with this option is that it allows you to customize the portfolio to your liking using the funds available. And, this method typically costs less in those ongoing fees I mentioned above.

If you go this route, you need to make sure you choose anywhere from four to ten or so funds that span the various sectors of the financial markets.  You want to have some exposure to large US companies and small ones.  You should have a certain percentage of your portfolio in foreign stocks.  And adding anywhere from 10-30% of your portfolio in bond funds is a good idea too.

If cost is the downside of the retirement date funds, complexity is the downside to this second approach. How you allocate your investments has a huge impact on your long term portfolio returns.  You therefore want to make sure you have your funds weighted appropriately.

And, unlike with the target date retirement funds, you need to worry about keeping your funds balanced over time.  What do I mean by this?  Hypothetically, let’s say you choose two mutual funds for your 401(k)  putting 80% of your 401(k) into the XYZ Company Stock Fund, and 20% into the XYZ Company Bond Fund. (Obviously, I made these funds these up to illustrate the concept.  And, you probably will want to have more than two funds if you aren’t using a target date retirement fund.  But, let’s keep it simple for now).  Now, let’s say that this year, stocks have a bad year, and bonds have a relatively good year (again, all hypothetical).  At the end of the year, even though you started 80% stocks/20% bonds, your portfolio might be 65% stocks/35% bonds, since the value of the stocks fell and the bonds rose.

When you are managing individual funds, you need to keep an eye on the portfolio being thrown out of balance in this way.  Typically, I recommend logging into your 401(k) twice a year and rebalancing to bring the portfolio back to 80%/20%, or whatever weighting you choose, to make sure it stays in line with your overall investment objectives.

In practice, once you have the portfolio set up appropriately, it isn’t that hard to rebalance it twice a year.  But, it a) takes a bit of time, and b) involves remembering to do it.  For this reason, I include rebalancing my clients 401(k)s twice a year as part of my comprehensive financial planning package.

Conclusion

You ultimately have two options- use the readymade target retirement funds, and pay a higher cost, or select the funds yourself and manage them independently.  There ultimately isn’t a “right” answer for everyone across the board.  And of course, if you have further questions about your investment options, how to rebalance, or even just to get a second opinion, I’m only a call away.

How Much Home Can You Afford?

Let’s admit it- renting an apartment just isn’t fun.

Dealing with a property manager. Making (overpriced) rent payments month after month without seeing any return on your money.  There are a lot of traditional appeals of owning a home.  It’s the American Dream!  It’s a great investment! (Side bar:  it’s not always a great investment). It’s a place that’s truly your own!  Among the newlyweds I talk to, all of these emotional factors play a role in deciding to buy a home. That being said, the primary motivator often is a financial one- they’re just sick and tired of writing rent checks every month.

But does it always make sense to buy a home?  There are lots of reasons for me to say “no”, but one I want to focus on today is cost.  How much does it truly cost to buy a home?  And, relatedly, how much home can you actually afford?

Shocking Fact: Not Everything You Read on the Internet Is True

If you type, “How Much House Can I Afford” into Google, the first links that pop up take you to calculators where you can plug in a few numbers and it will tell you how expensive of a house you can buy and have your mortgage payment be the same as your rent payment.  Problem solved, right?

Wrong.  Wrong, wrong, wrong.

The most common mistake I see newlyweds looking to buy a house make is that they use these calculators to back into a house value they think they can afford just by looking at how much the mortgage payment is compared to their current rent.  There are a LOT of other costs, which we will break down later, that add up quickly when buying a home.

Let’s take utilities as an example.  If you’re buying house that’s four times as large as the apartment you’re renting right now, it wouldn’t be unheard of for your utility bill to be four times as high for your house as it is for your current apartment.  Even if it’s not quite that extreme, you can still expect utilities on a full family home to be much higher than on a single bedroom apartment.  These online calculators leave things like this out.

Long story short, your monthly mortgage payment should be significantly less than your monthly rent payment.  To look at it another way- your mortgage payment should be no more than 30% of your gross (before tax) monthly income, and 25% is even better.

Before You Buy, You Need an Emergency Fund

It’s no secret that it costs a lot to buy a house.  Even though you’re taking out a mortgage, you’re still going to need to make a down payment upfront. And a big one, at that.

But, you should never equate “make a large down payment” with “have just enough in my savings to make a large down payment”.

Simply put, you need additional savings in an emergency fund before you even think about saving to buy a house.  Typically, I recommend having enough in an emergency fund to cover six months of living expenses if you were to lose your job.  I know that’s a tough mountain to climb for many people.  Don’t focus on the total, but rather the small steps you can take, starting today, to get there over time.  So, start by focusing on saving enough to cover one month of expenses, then two, and so on until you build up to six.

Emergency funds are a topic for another day. The important point here is that you should never use your emergency fund to pay for your down payment.  As tempting as it can be to grab that pile of cash when you’re trying to save for a big down payment, leave it be.  If you happen to lose your job a month or two after you buy your house, you’ll be glad that you did!

Speaking of the Down Payment… How Much Do I Need to Save?

Before you can make serious decisions about whether you are ready to buy a home, you need to have enough saved to make a down payment.  This is the biggest upfront cost, by far, that will help dictate how much home you can afford to buy.

Generally speaking, 20% is the golden number for a down payment.  In other words, take the listing price of the property you’re looking at, and take 20% of that value.  That’s how much you should try to save, up front, to buy the home.

There are mortgage payment options out there that will let you get away with having less than 20% saved.  But the more you put down up front, the better your mortgage terms will be, which is a goal worth striving for.

Other Upfront Costs

Unfortunately, the down payment is just the beginning.  There can be many more “hidden” upfront costs to buying a home that you should be prepared for.

The biggest items here typically are the closing costs.  Closing costs can run anywhere from 2%-7% of the home’s value, depending on where you are buying and what is included.  Closing costs include a number of charges, including attorney’s fees, inspection costs, title costs, mortgage application fees, and others.

Sometimes, you can have these costs be added to the value of the mortgage rather than pay up front.  You may even be able to negotiate with the seller to have them cover a portion of the costs.  But, you should be aware of them, and plan accordingly.

Other costs up front that many people overlook include moving expenses and, perhaps more importantly, furnishing a home.  Houses can be quite a bit bigger than a one bedroom apartment!  You don’t have to do it all up front, but keep in mind how much it will cost you to fill all of those extra rooms.

Ongoing Costs

This is where it can really add up.  First and foremost, one of the biggest advantages to renting rather than buying, which you’ll give up the second you move into a home, have to do with property taxes.  While you can be entitled to some tax deductions when you buy a home, your tax bill will likely rise as you will owe property taxes to your state and local governments every year. These vary drastically from town to town, state to state.  Do some homework ahead of time so you know what you’re getting yourself into.

Of course, landlords can be a blessing and a curse when you rent.  As a homeowner, you’re now responsible for all the maintenance to the property that they handled for you before.  And of course, first time homes for a family typically are relatively cheap, which means there are more likely than not a good number of maintenance issues to be addressed.  I usually recommend that couples looking to buy a home set aside 1-1.5% of the total property value  every year for home maintenance.

Those are the two big ones, but depending on where you live and the type of property you buy, there can be many other “hidden” costs to keep in mind, such as Homeowners’ Association Fees.

The Bottom Line…

I’m not trying to talk you out of buying a home.  Really, I’m not.  I think owning a home is a great goal to shoot for and can be a great investment for your future (but, like any investment, its not a sure thing).

My point is that you need to be aware of the costs of buying a home up front.  It’s not just as simple as comparing your rent payment to your projected mortgage payment- you need to go deeper and get a good, honest feel for the “unexpected” costs of owning a home.  That way, when you buy a home and sign the mortgage, you can be sure that you’re really ready.