Managing Your 401k
Very few employees (other than government employees) are offered a pension by their employers anymore. That older type of plan is called a “defined benefit plan” because the pension benefit is defined by the employer and backed by the employer’s ability to pay it. Often, the benefit is based upon the employee’s salary history and length of service, and it is usually a fixed or inflation-adjusted payout for the life of the employee.
These days most employees participate in a “defined contribution plan” in which the employee contributes a certain amount of compensation into the plan. Often the employer will also make contributions. But the employee is responsible for managing the investments, not the employer. Because most employees are not knowledgeable about investments, this can cause them to wonder if they are managing their retirement money prudently.
The purpose of this article is to provide some basic advice on how to manage your 401k (or 403b or 457) account well.
In general, your interaction with a defined contribution retirement plan has two stages: 1) when you are an active employee and 2) after you leave your employer.
As An Employee
Take Full Advantage of Your Employer’s Match
First and foremost, it is critical to take full advantage of any employer matching that is available to you. According to a 2018 study by Vanguard, the most common matching formula is 50% of employee contributions up to 6% of salary. Any employer match is free money. Don’t miss out. Where else can you get an immediate, risk-free 50% return on your investment?
In addition to reducing your taxable income, any money you contribute to your 401k will be sheltered from taxes as it grows. This is a tremendous benefit and helps money inside a 401k (or other tax-deferred account) grow much more quickly than money in a taxable account.
Save More if You Can
With a 50% match from an employer, if you contribute 6% of your salary to your retirement plan and your employer contributes 3%, the total contribution will be 9%. However, that may not be enough to provide a comfortable retirement. Many experts, including Fidelity, recommend saving 15% of your salary during your working years.
There are limits to how much you can contribute to a 401k plan, however. The maximum contribution allowed by the IRS in 2020 is $19,500. For those 50 and older, the regulations allow for an additional “catch-up” contribution of $6,500 in 2020, for a total of $26,000.
The simple and easy approach to retirement savings is to just concentrate on your employer’s retirement plan. However, it may make sense to consider using an IRA for the next tranche of retirement savings after maximizing your employer’s match. One good reason is to lower your costs. The total costs for an IRA account can be as little as .15% per year, for example. Most employer-sponsored retirement plans are considerably more expensive than that because of administrative expenses. Also, the breadth of investment choice in your own IRA is virtually limitless, compared to the limited offerings in most 401k plans, so you may be better able to diversify your investments with an IRA. Vanguard, for example, recommends this 401k – IRA – 401k hierarchy.
The complicating factor is that the IRS will start to phase-out the deductibility of your traditional IRA contribution beyond certain income levels, and at some point, eliminate the deductibility entirely. For example, in 2020, a couple filing jointly has a phase-out income range that begins at $104,000 and phases-out completely at $124,000. Because qualifying 401k plan contributions are fully deductible at any level of income, if your compensation is high enough to put you in or above the phase-out range, it makes sense to skip the IRA option and just keep contributing to your 401k.
Non-working spouses have a much higher phase-out range of $196,000 to $206,000 in household income, so they are much more able to make IRA contributions. Contribution limits for IRA accounts are much lower than for 401k plans, however. For 2020, each spouse has a maximum IRA contribution limit of $6,000 if under 50, and $7,000 if over 50. Also, IRA contributions must come from earned income from either yourself if you are working or your spouse if you are not. Therefore, the combined IRA contributions for both spouses must not exceed the couple’s total taxable compensation for the year.
Consider a Roth 401k and/or Roth IRA
Contributions to a regular or traditional 401k are considered “pre-tax” in the sense that they are not included in your taxable income. In recent years, many employers (85% in fact) have started to offer the option of making after-tax contributions to a Roth 401k. What’s the difference and how do you decide which is right for you?
In a traditional 401k, taxes are only deferred until distributions are made from the account, which is usually once required minimum distributions (RMDs) start. Under current law, RMDs start at age 72 (recently increased from 70 ½). In a Roth 401k (or a Roth IRA), contributions do not reduce your taxable income. However, since you have already paid income taxes on the money you contribute to a Roth account, distributions from a Roth are tax-free.
Both types of plans (traditional and Roth) feature tax-free buildup, meaning that you do not have to pay taxes on interest or dividend income or on realized capital gains. This is a very important advantage compared to a taxable account. Also, overall 401k contribution limits apply to the sum of traditional and Roth 401k contributions in any year.
How do you decide which is better for you? Since saving taxes now is generally preferred to saving taxes later, you might automatically assume that a traditional 401k (or IRA) is more attractive than a Roth. However, what really matters is not so much the timing of the tax payment, but the tax rate you pay. Differences in rate overwhelm differences in timing. This makes Roth 401k and/or Roth IRA contributions attractive to those who believe that their marginal tax rate (the rate paid on the last dollar of income) may be higher in retirement than it is currently. The Roth option may be advantageous for people in several categories:
- Early career. Often, your earnings early in your career are relatively low compared to what they will be later on. It may well be advantageous to use a Roth rather than a traditional 401k if your current marginal tax rate is relatively low.
- Transition. If you and/or your spouse have been laid off, perhaps because of the coronavirus shutdown, your earnings and your marginal tax rate may be lower this year than what you expect later on.
- Gap years. Approaching retirement, people often work less, or work at jobs that are less remunerative. Sometimes one spouse retires earlier than the other.
- Politically aware. Current marginal tax rates are lower than they have been in quite some time. This is an election year. The winds of political change seem to be blowing in the direction of higher tax rates down the road.
I have written more extensively about the potential advantages of using a Roth in an earlier article.
Push for Lower Administrative Fees
Most defined contribution retirement plan participants pay two kinds of fees:
1. Plan Administration Fees. In a few cases employers will cover this cost, but it’s much more common to see it passed on to the employee as a percentage of assets or a flat annual fee.
2. Investment Fees. Investment fees are what the fund itself charges for actually managing your investments, and they're usually the biggest expense. Most fund fees are included in the fund expense ratio, but sometimes there may also be a separate sales load paid to the selling agent or broker.
In a few cases, retirement plans may charge participants for other services, such as taking out a 401k loan, rolling assets over into an IRA account, or receiving personal financial advisory services.
Because the administrative and operational costs of a plan are somewhat fixed, larger plans with more participants tend to be much less expensive for the participants than smaller plans. Also, large plans may be better able to negotiate for lower cost funds and cheaper fund share classes. According to research by David Blanchett of Morningstar, average plan administrative fees range from 0.37% for large plans to 1.42% for small plans. (Note that this is on top of the expense ratio paid directly to each fund selected.)
Most people are quite ignorant about what they are paying in their retirement plans, even though the dollar amounts involved are large. Incredibly, a recent TD Ameritrade survey revealed that although 96% of those surveyed knew how much they paid for streaming services like Netflix, Hulu and Spotify, only 27% knew how much they paid in 401k fees. In fact, 37% believed that they didn’t pay any fees at all! Another 22% didn’t know if their plan had fees. The truth is that about 95% of plan participants pay administrative fees on top of fund fees.
Of course, most employees have little influence over the hiring of retirement plan administrators, the selection of funds offered, or allocation of expenses between employer and employee. However, it is possible for informed employees to bring some pressure to bear on their HR departments to lower costs.
Department of Labor (DOL) regulations require plan sponsors to disclose all fees and expenses to plan participants in a form called the “404(a) participant fee disclosure.” If you are a plan participant, this document should help you understand the fees you are paying. HR no doubt sends it to you automatically. Don’t just throw it out. Dig into it to uncover the costs you are paying.
Even better, find out how your company’s 401k compares to those offered by its competitors: Brightscope provides ratings on many larger plans and offers quite a lot of comparative information as well.
You might even want to suggest that your employer change the plan administrator. There are many excellent providers of 401k plans, but three organizations that I know offer low cost plans are Vanguard, Betterment, and Guideline.
Select Low-Cost Funds
You may not be able to change the administrative costs of the 401k plan offered by your employer. And it may not be possible to persuade your employer to offer index funds as a cheaper alternative to expensive actively managed funds. But you can control which funds you invest in. At a minimum, you should know the expense ratios of the funds offered by your plan.
Unfortunately, when plan participants are presented with a summary list of funds, the information most frequently and prominently provided for each fund consists of historical returns. As if that is any basis for making a fund selection! Often expense ratios aren’t even provided!
Let me state this as clearly as I can. Historical fund performance is completely meaningless. Short-term performance or long-term performance, it’s all the same: you should ignore it. On the other hand, expense ratios are the single best predictor of relative fund performance. The cheapest funds are the ones statistically most likely to outperform. Focus on the expense ratios.
Index funds tend to have much lower expense ratios because they do not have to pay portfolio managers (one of which I was) to actively pick stocks. The truth is that the vast majority of actively managed funds fall behind their benchmark indexes, and the average shortfall is roughly equal to the costs of active management. This makes intuitive sense, and is, in fact, a mathematical tautology. If the sum of all actively managed portfolios is “the market,” and the market index merely replicates the market, then by necessity the market index must on average outperform actively managed funds by the average amount of their expenses. Q.E.D. Index funds typically charge only a few basis points and avoid the costs of active management, therefore they outperform on average.
An Easy Choice: Target Date Funds
Fortunately, most plans these days offer a “default option,” and it is usually a set of “target date funds.” These are usually a good option for most people. The basic idea is to select a fund that corresponds to the year in which you are likely to retire (your retirement “target date”). However, you shouldn’t feel constrained to blindly invest in whichever fund lines up with the year in which you turn 65. You should feel free to be more or less aggressive than your expected retirement date might indicate, according to your individual preferences and circumstances. You can shift into a fund with a nearer target date to be more conservative, and to one with a further out target date to be more aggressive.
One of the attractive features of target date funds is that they make diversification easy and automatic. Target date funds combine U.S. and international stocks and bonds in allocations that a sophisticated organization has determined are prudent. As time goes on, the fund gradually decreases its allocation to stocks and increases its allocation to bonds and cash. You don’t have to worry about it: it’s done for you.
For most people, especially early in their careers, the main thing is to actually participate in the plan and save aggressively. How you are invested is not as important. As time goes on and your portfolio gets larger, however, investment considerations start to loom larger, and deserve more attention.
There are several potential disadvantages to target date funds. Cost may be one. Unless the target date fund uses index fund components, it is likely to be more expensive than a do-it-yourself approach using mostly index funds. The other main concern is the attractiveness of the asset classes included in the asset mix, and their weights. Target date funds are designed to be simple. To have mass appeal, target date funds must be easy to understand and conform to the general expectations and desires of most investors. Sometimes, simple means simplistically sub-optimal.
One glaring example of the potential sub-optimality of target dates funds are the Vanguard Target Retirement Funds. Perhaps because of their almost fanatical belief in market efficiency, Vanguard (more than most fund companies) uses the composition of the global capital market as a guide for the asset mix of their target date funds. In particular, most target date fund providers do not include a major allocation international bonds (if any), despite their large weight in the global capital market, partly because of currency risk and partly (in recent years) because of their low, or even negative, yields. However, Vanguard Target Retirement Income Fund (VTINX), the target date fund designed for investors already in retirement, currently allocates 15.7% to Vanguard Total International Bond Index Fund (VTABX). Because so many European and Japanese government bonds have negative yields, the 30-day SEC yield on this fund is only .48% (per year!). And its duration (interest rate risk) is a whopping 8.3, which is 30% more interest rate risk than the U.S. bond market! This is not a rational investment.
A Smart Choice: Index Funds and a Stable Value Fund
Unfortunately, not all 401k plans offer index-based target date funds. It is much more lucrative to offer actively managed funds. However, because of the scrutiny that the Department of Labor is bringing to bear, most plans offer at least one equity index fund.
You might be better off with the bulk of your equity exposure in one or more cheap index funds as opposed to more expensive actively managed funds, including those within target date funds. Because most types of equity funds have a very high correlation to each other, the optimal (and most cost-effective) way of capturing equity market return is likely to be through one or more index funds, even if certain exposures (small cap, emerging market, real estate) must either be added through a separate IRA account or ignored altogether. (Correlation is a statistical measure of how well two assets diversify each other. The highest correlation is 1.0 which indicates no diversification benefit. The lowest is -1.0, but negative correlations are rare. Money market funds have a correlation of zero with other assets, which provides a very high level of diversification.)
For the fixed income component of your 401k, you might consider using a “stable value fund” if your 401k plan offers one. Larger plan sponsors often do. This type of fund has no volatility whatsoever (like a money market fund) but offers a stated yield that is usually quite a bit higher than money market fund rates.
How are they able to produce this financial alchemy? It has much to do with the presumed stability of the investors in the stable value fund. The managers of the stable value fund count on the turnover within the fund to be very low (which historically has been a valid assumption). This stability allows the managers to invest in less liquid, somewhat variable assets, typically bonds, that offer higher yields.
Regular bond funds these days offer a very unattractive set of return/risk tradeoffs in my opinion. Yields are extremely low, and not much additional yield is offered for taking on unhealthy amounts of either interest rate risk or credit risk.
Consequently, for those who can, I suggest investing in some combination of equity index funds (typically a U.S. index fund and perhaps an international index fund if one is available) along with an allocation to the stable value fund for the bond/cash portion. If your 401k does not offer a stable value fund, you could substitute a money market fund or short-term bond fund.
To help you determine an appropriate equity/fixed income asset mix, you might look at the allocations of the target date funds offered by your plan as reference points. Ongoing management of the asset mix will be your responsibility. You will have to “rebalance” (adjust the asset mix) back towards to your long-term targets if they get out of line.
Do Not Diversify by Fund Categories or Style Boxes
In the old days, fund companies used to try to categorize their equity funds with labels such as “aggressive growth,” “growth,” or “growth and income.” These labels are, and always have been, completely meaningless. You should ignore them.
Nowadays, it is much more common for funds to pigeonhole themselves according to “style boxes.” Morningstar made style boxes famous. Their version is a nine-box grid with size (large, mid, small) along one axis and style (growth, core, value) along the other. The common presumption is that you should have assets allocated to all nine boxes in order to be “well-diversified.”
This is utter nonsense. If you have a balance of growth, core, and value, what you really have is a net investment in core, which of course includes a balance between growth and value, and can be had very cheaply through an index fund. Specific allocations to growth and value tend to be expensive because most of the time the choices in those categories are actively managed funds with high expense ratios. People are lured into buying them with attractive historical performance figures. You are too smart for that.
Large cap funds constitute 80%-90% of the total market cap of all equities (both in the U.S. and internationally). Sometimes, 401k plans offer “total market” index funds that include smaller cap stocks, but this is rare. Generally, only large cap index funds are available. If your desire is to own the entire market, only a small allocation needs to be made to a small cap fund. And you will not have a major hole in your portfolio if you omit small cap completely.
Diversify by Asset Class
Let’s be clear: by far the most important decision you will make in your 401k account is how much to invest in equities. That single decision will overwhelm everything else in importance as far as your long-term return/risk trajectory. A distant second in importance is how much U.S. equity vs. international equity. All other considerations come after those two.
U.S. Equity. Nearly all types of U.S. equity investments are highly correlated to each other. For example, the various U.S. value and growth indexes tend to have correlations to the “core” U.S. equity market (S&P 500 Index or Russell 1000 Index or “Total Market Index”) of over 90% over longer periods of time. Even small cap indexes (like the Russell 2000 Index or the S&P 600 Small Cap Index) have correlations with large cap indexes of over 80% for the most part. Size and style are “second order” considerations at best. Unless you have some sort of special insight into which is going to outperform, value or growth, large or small, you are probably better off sticking with large-cap or all-cap core allocations, especially if (as is often the case) only these major allocations are available in index funds within your 401k.
Since over 90% of the total risk in even a well-diversified balanced 60/40 portfolio is equity market risk, the primary task of the rest of the portfolio is to seek to reduce that risk through diversification. The lower the correlation between two asset classes, the better they diversify each other.
International Equity. The correlation of the U.S. stock market with developed non-U.S. markets has increased over time as global markets have become more open and integrated. Recent correlations have been over 80%. Even at that level, there is still some diversification benefit to international investing. In addition, the fact that about half of the global equity market is outside of the U.S. means that omitting international equities entails ignoring about half of all equity investment opportunities. Financial theory suggests that a representative slice of the overall global capital market pie is a good starting point for constructing a well-diversified portfolio. There are good reasons why most investors do not have half of their equities in non-U.S. stocks, but by the same token, not having any at all would be an extreme bet.
Emerging market indexes have lower correlations with the U.S., often as low as 60%-70%, and so provide better diversification benefits than developed markets. However, this comes with higher levels of volatility and risk. Emerging markets constitute about 11% of the global equity market, so that level of allocation is a logical starting point.
Real estate. The definition of “real estate” is somewhat fluid, but without a doubt this asset class constitutes a large portion of the global capital market. However, real estate tends to be under-represented in publicly-traded equity indexes because so much of institutional (non-residential) real estate is owned privately. Correlations for U.S. and international REITs tend to be akin to those of small-cap and emerging market equities, so they provide a meaningful amount of diversification potential relative to U.S. equities. Having a meaningful allocation to real estate will require investing in a REIT fund, which may not be an option in your 401k fund lineup. This is one example where having an IRA account may come in handy.
Fixed Income. Bonds can be separated into U.S. and international categories. However, international bonds are extremely unattractive (for the most part) at present. A large number of developed market international bond markets sport negative yields. Avoid them! Emerging market bonds have more attractive yield and diversification effects but are a very small slice of the global capital market, so omitting them is certainly acceptable.
U.S. bonds tend to have a very low correlation with U.S. stocks, and so do an excellent job of diversifying equity risk. That’s the good news. The bad news is that U.S. bond yields (while not negative) are extremely low by historical standards, so their return is likely to be paltry. Unlike stocks, you can know what your expected return is before you invest in a bond or bond fund. (Your actual return may differ if interest rates change or there are defaults.) A bond is a contract with fixed terms. The “SEC yield” is generally best indication of expected return, and is a figure that is readily available on most bond funds.
Bonds have two kinds of risk, and both will increase your yield and expected return: interest rate risk and credit risk. Interest rate risk is measured by “duration,” or more specifically, “modified duration,” which is a mathematical gauge of the sensitivity of a bond or bond fund to changes in interest rates. If rates go up, bond and bond fund prices go down, resulting in capital losses. The amount of incremental yield available for taking on incremental interest rate risk is measured by the “Treasury yield curve.” Currently, the yield/duration tradeoff is very unattractive. For example, the 30-day SEC yield of the iShares 20+ Year Treasury Bond ETF (TLT), a fund focused on long-term Treasury bonds, is only 1.30%, but the effective duration is 18.91. That means that if interest rates rise by 1%, investors in TLT will lose 18.91% of their money! (Full disclosure: I am currently short TLT.)
More incremental yield can be had in the current environment by accepting credit risk. This entails investing in corporate bonds. For example, the Vanguard Total Corporate Bond ETF (VTC) has a 30-day SEC yield of 3.09%. The duration is 8.3, however, so it is not without interest rate risk. Also, credit risk is highly correlated to equity market risk. If the main purpose of your bond investments is to diversify your equity market risk, corporate bonds will not be nearly as effective as government bonds. For example, my proprietary risk model indicates that VTC has an equity market “beta” of .24, which means that owning it is like investing 24% of your money in the S&P 500. VTC’s recent correlation with the S&P 500 is 61%. By comparison, TLT’s S&P 500 correlation is -50%. Treasury bonds are much better at diversifying equity market risk than corporate bonds.
My advice is to only accept risk when you are being adequately compensated for doing so. Right now, very little additional return is offered for interest rate risk, so don’t take it. Yield pickup for credit risk is below average, so I would urge caution in accepting much of that either. A very short-term bond fund, money market fund, or stable value fund will not provide much return but with a correlation and beta to equities of something close to zero, it will lower the volatility of your portfolio and diversify your equity market exposure.
Get Low-Cost Professional Help
If at this point you are mentally throwing up your hands in dismay at the complexity of it all, but you do not want to return to the simplicity, and potential sub-optimality, of a target date fund, then there is another option I can suggest: Blooom. (Yes, there are three “o’s”.) Blooom's entire business is employer-sponsored retirement account analysis and management. This covers 401k accounts, as well as 403b and 457 accounts. Blooom has direct links with hundreds of different 401k providers which enables them to make changes directly to your account if you engage their premium plan. You can do this directly—you do not need your employer’s permission. You can start by using their free online analysis tool, but they can also manage your 401k account for you for as little as $10 per month.
As An Ex-Employee
Once you leave your former employer, you have four choices of what to do with your 401k account:
• leave the money in your former employer's plan, if that is permitted;
• roll over the assets to your new employer's plan, if one is available and rollovers are permitted;
• roll over to an IRA; or
• cash out the account value.
Let’s discuss that last option first and get it out of the way.
Do Not Cash Out
There are at least three reasons why you should not cash out your 401k:
- The 10% penalty. In most cases, unless you are over 59 ½, you will pay a 10% penalty for early withdrawal.
- The income taxes. When you take cash out of a 401k, it becomes taxable income. The IRS requires a 20% tax withholding on distributions. (You may get some of it back after you file your taxes if 20% turns out to have been too high in your case.)
- Losing the tax-free buildup. Money within a tax-deferred vehicle like a 401k or IRA will grow much faster than money in a taxable account because you do not have to pay taxes on interest and dividend income or on capital gains until you withdraw from the account.
It is likely that if you cash out your 401k, you will be robbing yourself of money that you will wish you had for retirement. That said, there are certain exceptions that might make it possible to avoid the 10% penalty for early withdrawal, including financial hardship that the IRS considers “an immediate and heavy financial need.” However, most experts agree that cashing out should be a last resort.
Compare Costs and Investment Options
Assuming that we are left with the other three choices (leave it, move it to your new employer’s plan, or roll it over into an IRA), the first and most obvious consideration is to compare costs. In the first section above we discussed using the required “404(a) participant fee disclosure” to examine the fees charged by your 401k. Having this information will allow you to compare the costs involved in your various options.
Generally speaking, the operating costs involved in maintaining your own (“self-directed”) IRA account are minimal compared to the costs of participating in a 401k. Most mutual fund companies and online brokers charge either nothing or at most a small annual fee to maintain your account, and usually waive any fee if you agree to receive documents electronically or if you meet a minimum asset size.
Also, your fund choices become virtually limitless in an IRA, so you are free to invest in low-cost index funds and ETFs.
On the other hand, the very largest 401k sponsors may offer private or “institutional” funds to their plan participants, which can be extremely cost-effective and which you will not be able to access through your IRA. Also, stable value funds are only available to plan participants.
Costs matter, and should probably the main driver of your decision, but there are other considerations as well.
Consider Information, Access, and Control
As a former employee, you may not have as much access to the HR department as you did when you were an employee. This might be merely an inconvenience in most cases, but if the company enters bankruptcy and this catches you unawares, it could mean that your 401k is frozen for a time while the court sorts things out. On the other hand, if you are considering personal bankruptcy, money within a 401k will generally provide greater protection from creditors than an IRA account.
Also, many 401k plans allow plan participants to borrow against their accounts under some circumstances. This provides flexibility to get at money when needed without triggering the 10% early withdrawal penalty, and without reducing the balance invested. Generally, funds borrowed from a 401k must be paid back within five years. Although the IRS allows for certain hardship withdrawals from IRA accounts, the rules tend to be tighter, and IRA withdrawals reduce the account balance and become taxable income.
You will have a lot more control over your own IRA account, however. IRAs have standardized rules set by the IRS. Sponsors of 401k plans establish their own rules and are also able to change them.
One aspect of control kicks in upon your death if you are a plan participant. Most plan sponsors pay a lump sum to beneficiaries. That is not as tax-efficient as spreading out the distributions over a number of years, as IRS rules allow for inherited IRAs.
Special Circumstances: Roth 401k and Company Stock
If you have a Roth 401k, it is probably best to roll 100% of that money into a Roth IRA as soon as possible after you retire, or even before. There are two main reasons for this. First, the rules governing a Roth require a five-year waiting period after you have deposited funds into a Roth IRA before you can begin to draw them out. Second, IRS rules require minimum distributions from a Roth 401k account starting at age 72 (up from 70 ½ under the new law), just like with a traditional 401k, whereas there are no RMDs for a Roth IRA.
You can keep the money in a Roth IRA as long as you want. Roth IRA money can be passed along to beneficiaries at your death with the same tax-free distributions that apply to your use of the money. However, non-spouse beneficiaries will have to withdraw all funds within 10 years, just like they do when inheriting a regular IRA.
If your 401k account includes company stock that has greatly appreciated, you are likely better off transferring that stock into a taxable brokerage account. You will have to pay income taxes on the original purchase price of the stock, at your regular income tax rate, so you may want to delay the transfer until your income has gone down in retirement and you are in a lower marginal tax bracket. Once the stock is in your taxable brokerage account, you will be able to delay paying taxes on the gains until you sell the stock. And even then, the tax will be at the long-term capital gain rate, which is usually quite a bit lower than regular income tax rates. (At least, it is at present.)
Be Careful with the IRA Rollover
Most people end up doing an IRA Rollover when they leave their job. However, it’s important to get the details right. The best way to do a rollover is with a “direct rollover,” which means that your 401k administrator will cut a check directly to your IRA account, not to you personally. An “indirect rollover” means that the check is made out to you personally, with 20% in taxes taken out. You have 60 days to deposit the check, plus the 20% withheld in taxes, into a new IRA account. (You will have to get the 20% withholding back after you file your taxes.) Otherwise, your distribution will be completely taxable to you—a disaster!
You do not need to be in a hurry to do anything with your 401k. In fact, you can decide to leave some of it and move some of it. You may want to first roll over any Roth 401k money into a Roth IRA to start the clock on the five-year minimum holding period and avoid RMDs. Then move money out of higher-cost funds into lower-cost funds within your IRA. You may want to leave money invested in very low-cost funds, or funds that are not available to those not in the plan (such as a stable value fund), in the 401k for the long-term.
Your 401k is your ticket to financial security in retirement. Save 15% of your income if you can, but in any event be sure to contribute at least enough to get the full matching contribution from your employer. Keep your costs low by emphasizing funds with low expense ratios, such as index funds. Don’t worry too much about including all kinds of different funds that sound like they would diversify each other—all equities are highly correlated to each other. The main decision you need to make is how much to invest in equities vs bonds and cash. Do not sell in a panic if the market falls. Rebalance if you get too far from your long-term targets. Target date funds will do all of that for you, but you can also do it yourself. Ultimately, you are in charge of your financial destiny.