Q&A #25 - New job...what to do with my 401k?

Q: I am taking a new job with another company.  What do I do with my 401K (a regular 401K, not a Roth 401K) from my current company?

A: Convert your 401K to an IRA or a Roth IRA.  This is called a rollover.  It’s pretty simple to do. 

• Call the fund company where you want to open the IRA.  I recommend Vanguard, but it could be Fidelity or T Rowe Price or some other.  Tell them what you want to do, and let them step you through the process.  They have all the forms you need on-line, or they will mail you the forms if you like dealing with paper.  These forms will allow you to transfer the money directly from your 401K trustee (the company that administers the 401K) to the Roth IRA without you actually touching it.
• Roll over the entire 401K.  Don’t decide you need a new dining room set and keep some money for yourself.  You’ll get hit with penalties and taxes and it is just too complicated.
• Don’t ask the 401K trustee to send the money to you.  That’s a bad idea, because you only have 60 days to get it deposited into the IRA.  If something goes wrong and you miss the deadline, you are screwed.  It’s much better to do a trustee to trustee transfer.
• The rollover IS NOT an IRA contribution.  It is a completely separate transaction.  So if you are rolling over $140,000 you don’t have to worry that it exceeds the annual IRA contribution limit.  Similarly, if you make a rollover, you can also contribute to the IRA for the same calendar year, up to whatever the contribution limit is in that year.  The contribution limit for 2009 is $5000 if you are under 50 and $6000 if you are 50 or over.  If you earn less than these amounts in 2009, then you can’t contribute any more than your “earned income”.

Next question.  Should you use a regular IRA or a Roth?

I say Roth IRA.  It’s a much better product for Gen Y people. 

Two problems with using a Roth IRA.

First, you can’t roll over the 401K money to a Roth if your income for 2009 (single or married filing jointly) is $100,000 or more.

The solution to this problem is to roll over your 401K money to a regular IRA this year.  Next year, the 100,000 income limitation goes away, and you can convert your regular IRA to a Roth IRA with no problem.  This assumes that Congress doesn’t make any changes in between.

Second problem……taxes.  If you roll over a regular 401K to a Roth IRA, or convert a regular IRA to a Roth IRA, you have to pay income tax on the money the same year that you make the rollover.  That’s income tax, not capital gains tax.  You can’t use some of the retirement money to pay the taxes.  You need to pay your taxes with non-retirement funds.

Depending on the amount you roll over, the tax bite can be pretty big.  Here are a few ways of dealing with the taxes:

• Roll the money into a regular IRA this year and convert the regular IRA to a Roth IRA in 2010.  If you do this, the government lets you spread out the tax payments over 3 years.
• If you know you will be going back to college for an MBA in the next few years, roll over your 401K into a regular IRA now and convert to a Roth IRA while you are getting the MBA.  Since you won’t be earning any other money while you are getting your MBA your tax bracket will be lower.  Which means the tax bite on the money you converted to the Roth will be lower.
• Roll over your 401K money into a regular IRA now and then convert the regular IRA to a Roth a little at a time over a period of five or ten years.  That way you don’t get hit with a big tax bill all in one year.

Understand that if you keep your money in a regular IRA, you will eventually pay taxes when you withdraw the money (starting at an optional 59 ½ or a mandatory 70 ½).  As opposed to converting the money to a Roth now, paying the taxes when you do the conversion, and then not having to pay taxes when you make the withdrawals.  It’s not like you’re escaping taxes with a regular IRA, you’re just postponing them.  Plus, you pay taxes on all the earnings in your regular IRA (when you withdraw the money). 

The question is, do you think your tax rate will be higher when you are taking the money out thirty or more years from now or will it be higher this year?  Most people think it will be higher when you are older.  This means it’s better to convert to a Roth now and pay the piper up front.

Here’s a link that explains things in detail.  Read it carefully to get familiar with all the rules.

7 steps to a Roth IRA conversion

Besides tax rates, remember two big advantages of Roth IRAs.

1. You don’t pay taxes on earnings.  All withdrawals (after 59 ½ ) are completely tax free. 
2. You are never forced to withdraw the money.  Whereas with a regular IRA you must start taking distributions by age 70 ½.

Why is the non-mandatory withdrawal feature an advantage?  If you have a decent amount of assets when you are 70 ½, you can leave the money in the Roth, growing tax free.  With a regular IRA, you are forced to take some of the money out each year starting at 70 ½ , and this money cannot grow on a tax free basis any more.   It’s always better to have money grow tax free than to grow in a taxable account. 

Let’s assume that you have rolled over your 401K money into the Roth IRA.  What next?  Go back and re-read the “Summary of Important Retirement Points” in post number 31.  Follow the guidelines in post 31 for your future retirement contributions at your new job.  

Keep in mind that if you are filing your taxes as a single and your adjusted gross income (AGI) in 2009 is $120,000 or higher, you can’t contribute to a Roth IRA.  Between $105,000 and $120,000 you can make reduced contributions.  If you are married filing jointly, the contribution starts to phase out at an AGI of $166,000 and goes away completely at $176,000.  These numbers change from year to year, so you need to keep up with the rules.  In the event that you are locked out of a Roth IRA contribution for a specific year, contribute to a regular IRA.  There may be many years (I hope) where you earn so much money that you are forced to contribute to a regular IRA rather than a Roth.  That’s OK.  Keep contributing.

And somewhere down the road, if you take time off to find yourself or decide to become a stand up comic, you may find that you are earning $28.52 per week.  That would be a good time to convert the regular IRA money to your Roth IRA.