Many money savvy young professionals utilize retirement accounts to invest money and minimize their yearly tax bill. While doing so is great for wealth creation, many people are unsure of what to do when they change jobs. Maybe you’ve wondered the same thing? Perhaps you’ve contributed 5-10% of your salary to your work retirement plan and now find yourself in the transition period about to work for a new employer. While you are excited about the new job, maybe you wonder what to do with the retirement account you had at your old job. Here are 5 options to consider:
Option 1: Leave it where it is. If you like the retirement plan options at your old job and the fees are low just let the money stay there and continue to grow. Unless your old employer demands that you move it, you can likely just the money you contributed in that same account. Although you can’t continue to contribute to that particular work-sponsored account if you no longer work there, you can let the money you already invested keep building over time. You can start withdrawing the money from that account at age 59.5 without incurring any early withdraw penalties but you must start withdrawing it by age 72. If you like the investment options offered by your employer, such as standard low-cost index mutual funds, then keeping the money where it is may be a good option.
Option 2: Roll it into your new job’s retirement plan. This may be a good option if you’re not particularly thrilled with the 401K options at your old employer and like the retirement plan investment options at your new job better. It may also be a good idea if you don’t want to keep track of multiple different 401Ks (or 403b’s) and would prefer to have them all at the same place. If you want to rollover the money into your new job’s retirement plan you simply contact the custodian or manager of the 401K (or 403b) plans at your old job and let them know you want to rollover the funds into the 401K (or 403b) at your new job. This a direct transfer. All you have to do is fill out some paperwork. (Some jobs may make you wait until you’ve been at the new job for a certain length of time before they let you do the rollover so contact your new job and ask). Since the money is going from one pre-tax retirement plan (at your old job) to another pre-tax retirement plan (at your new job) you won’t owe any taxes. You are simply combining 2 accounts into one. If you don’t want to do a direct transfer, you can also have the person in charge of your job’s 401K write you a check for the money and you can then deposit that check into your new job’s 401K yourself. (By law, you must make the deposit within 60 days.)
Option 3: Put the money in a traditional IRA. With this option, you call a brokerage firm like Fidelity, Vanguard, etc and let them know you want to open an individual retirement account (I.R.A) or tell them that you want to roll money from your old job’s retirement plan into your existing IRA. Putting the money into a traditional IRA may be an option for people who may not have good retirement plan options at their new job or want a bit more control over their investment plan options. The biggest advantage of opening an IRA this is that you now will have control of your retirement account and it won’t be controlled by your employer. With this control you can invest in whatever you want, whether that’s individual stocks or various mutual funds you find appealing. You also do not have pay any extra money in taxes when you transfer the funds. Through a self-directed IRA, which is a traditional IRA that you have control over, you can even invest in things like real estate, art, business partnerships, and precious metals. The downside of putting the money in a traditional IRA is that you will now be excluded from using the backdoor Roth IRA method which allows high income earners to put money into Roth IRA accounts each year.
Option 4: Convert it to a Roth IRA. Choosing to convert your work 401K (or 403b) into a Roth IRA is different from putting the money into a traditional IRA. Unlike a traditional IRA, which you contribute to with pre-tax dollars, you contribute to a Roth IRA with post-tax dollars. In other words, you contribute to a Roth IRA after taxes have already been taken out of your check and you never have to pay taxes on that money again. Why does this matter? Because with a Roth IRA you can invest in a way that allows your money to make even more money over time and you never have to pay taxes on the profits. Plus, you can take your contributions out of the Roth IRA at any time without any penalties which means it can serve as an extra emergency fund. In order to convert the money in your 401K (where you made contributions with pre-tax dollars) into a Roth IRA (which you contribute to with post tax dollars), you have to pay taxes on that money. For example, if you have $10,000 in your work 401K, and your marginal tax rate is 25%, then converting your 401K to a Roth IRA will increase the amount of taxes you owe by $10,000 x .25 = $2,500. This may seem like a lot of money now, but when you take the money out in retirement you may be paying an even higher amount in taxes since the overall amount in the amount will have grown over time. Before you decide what to do, see how much money you have in your 401K and calculate the taxes you’d have to pay if you converted it to a Roth IRA. If you can handle the increase in taxes, then converting it to a Roth IRA may be worth it.
Option 5: Cash it out. Technically speaking, you can cash out your 401K at your old job and have them write you a check for you to spend on whatever you want. This may be something to consider if you need the money to buy a home, pay off debt, or use for some other reason. While it may be nice to get an influx of cash, understand that the amount you get may be much less than you think. Since you did not have to pay taxes on money that went into the 401K, if you decide to cash it out, you will have to pay taxes on that money. Plus, if you are under age 55, you will also incur a 10% early withdrawal penalty. For example, if you have $15,000 in your work 401K and you want to cash it out, realize you will not get a $15,000 check. If your marginal tax rate is say 22% and you are under age 55, then you will only get a check for around $10,000 (only 2/3 of the money you had in the account) once you account for taxes and the early withdrawal penalty.
My point? You have 5 options of what to do with your 401K (or 403b) when you change jobs. In order to avoid paying a lot in taxes, some people tend to leave the money where it is or roll it into their new job’s 401K. If they can afford the taxes, then they may try to convert it to a Roth IRA to save themselves money in taxes later in life. Other options are to put it into a traditional IRA or cash it out. The choice is yours.
The 5 Index Funds in my Investment Portfolio
Unlike many investors, I don’t buy or trade individual stocks. I explain in detail why I’ve bypassed this new trend in a previous blog, but the main reason I don’t buy or trade individual stocks is because the price of stocks changes too quickly. It’s hard to predict if a stock will go up or down. Since stock prices are so volatile (and change so often) there is an increased risk that I might lose money. My goal is to invest in a way that increases the chance I’ll make a profit but has a low risk that I may lose money. The main way I maximize profit and minimize risk is by investing in index funds.
Index funds are groups of many different stocks that follow a certain index. For example, one index fund may follow the S & P 500 index and purchase hundreds of stocks from American companies. Another index fund may be filled with thousands of stocks from all around the world. There are many different choices. When you purchase an index fund you are buying a fund that has purchased a percentage of all the stocks in that index. By purchasing a percentage of hundreds or thousands of stocks, you have better diversification in your investment portfolio with much lower risk of losing money.
There are many different choices of index funds to choose from. I have accounts at Vanguard and Fidelity (which are two of many different types of brokerage firms). Through these companies I have chosen 5 main index funds:
1. Total Stock Market Index Fund I invest in this fund at Vanguard through my employer-sponsored retirement account at work (called a 403b which is very similar to a 401K). I also invest in this fund through my Roth IRA at Fidelity. This index fund has a portion of over 3,600 stocks from small, medium, and large sized American companies. With this fund, I own a portion of all the stocks in the United States. The greatest percentage of money in this fund is invested in Apple, Microsoft, Amazon, Facebook, Google, and Tesla. It also has much smaller percentages of thousands of other companies. Altogether, this fund has made over 20% in profit over the last year and 15% in profit over the last 5 years.
2. Total International Stock Market Index I also invest in this fund at Vanguard through my 403b and through my Roth IRA at Fidelity. Unlike the previous index fund, this particular fund has over 7,000 stocks from all over the world. 38% of these stocks are from European countries. 24% of these stocks are from emerging markets in developing countries. 26% are from countries in the pacific and about 6% are from countries in North America. This fund has made over 11% in profit over the last 5 years.
3. Total Bond Market Index Fund I invest in this fund at Vanguard through my work 403b. This fund buys almost all of the bonds in the United States. Since these are bonds, there is much less risk that I will lose money but because of this extra caution, the returns aren’t as great. This fund has over 10,000 bonds with 63% of them being US Government bonds. It has made a return of about 5% over the last 5 years.
4. Total International Bond Market Index Fund I invest in this fund at Vanguard through my work 403b. This fund buys bonds from all around the world. This fund has over 6,000 bonds with over 57% of them from Europe. It has made a return of about 4% annually over the last 5 years.
5. Real Estate Index Fund I invest in this fund through my Roth IRA at Fidelity. This fund is filled with lots of smaller real estate funds that are full of many smaller real estate deals. I chose to invest in this fund in an effort to add some real estate investments to my portfolio. Over the last 5 years, this fund has had an average annual profit of 5%..
Overall, about 20% of my money is in real estate index funds, 5% in bond index funds, and 75% is in stock index funds. What is the makeup of your investment portfolio? Are you using index funds?
4 Reasons to Open a Roth IRA
I am a huge proponent of saving and investing money for retirement, even as a relatively young professional. One of the best accounts to use is a Roth IRA. Here are 4 reasons why.
1. It allows you to save/invest money for retirement which can help you build your net worth quicker. A Roth IRA is a type of retirement account that you can invest in with income you earn from your job. The benefit of contributing money into this account is that although the account technically is for retirement, it has many other benefits as well. One of the biggest benefits is that it allows you to invest money in a way that builds your net worth quicker (since there are fewer fees and taxes associated with it). The sooner you are able to build your net worth, the more options you will have in life. Not only can you retire early, but you can also choose to work part-time, accomplish many of your financial goals a lot sooner, and rethink how you want to spend your life. If you choose to stay at your current job you may do so, but if you decide you instead want to take a year-long sabbatical to travel or work for a non-profit organization you can do that as well. Building your net worth sooner rather than later allows you to re-define how you want to spend your life. Investing in a Roth IRA makes this easier.
2. It’s tax-efficient, so you don’t have to pay taxes on the profits or the withdrawals. Taxes may not be the top thing on your mind, but when it comes to making and investing money, it is something that I think about often. The taxes you pay each year, from each paycheck, is likely your largest expense. If you are able to find ways to reduce your taxes, then you’ll likely have a lot more money in your pocket each month. One of the reasons I like the Roth IRA is because it’s tax efficient. Instead of having to pay taxes on the profits you make from your investments or paying taxes when you withdraw your money from the account later in life, a Roth IRA works differently. Since you contribute to a Roth IRA with earned income from your job (which is money that you have already paid taxes on), you never have to pay taxes on that money again. This means that any profit you make from your investments is tax free and you don’t have to pay at least 20% in taxes like many other people do with other types of accounts. Plus, when you withdraw the money in retirement, that money is also tax free.
3. There is more flexibility on when you withdraw money, so it can serve as an extra emergency fund. Unlike many employer-sponsored retirement plans like a 401K or a 403b, a Roth IRA is not tied to your place of employment. This means you have a lot more flexibility in the type of investments you can make. Instead of being limited to the funds supported by your job, you can use a Roth IRA to make various other real estate or stock investments. You also have a lot more leeway on when you can take the money out of the account. Although the goal is to leave money in the Roth IRA until you retire, you can take out the money you contributed sooner rather than later if you need. In fact, as long as you leave the investment profits you make inside the account, you can withdraw your contributions at any time tax-free. This means if you desperately need the money to pay off student loans, buy a home, or move to a new city, you can technically just withdraw the money from your Roth IRA account to do so. It can serve as a back-up emergency fund.
4. You can give the money to your children tax-free, which gives you an extra way to leave your family an inheritance. I am a single young professional with no kids, yet. However, at some point, I’ll have children and would ideally like to leave them an inheritance. Unlike other accounts you can set up for your children as an inheritance, any money you give your future kids in a Roth IRA is tax-free. This means they won’t have to pay any taxes on this money when they get it. The less taxes they pay, the more money they keep. Thus, each year you can contribute to your employer sponsored retirement accounts to work on building your own net worth AND contribute to Roth accounts which you can then use as extra money for yourself and eventually gift to your children as an inheritance.
