Should I Roll Over My 401K or Qualified Retirement Plan?
February 19, 2021
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Is it ridiculous to think about moving your old 401(k)? I’m mean I get it; you already picked the funds you wanted, you look at the statement every once and a while and as long as it is generally going up over time that’s fine right? “If it ain’t broke don’t fix it” is what my Dad always told me. But is that really what is going to serve your goals the best long term?
Picture this; you’re shopping for a new car and the sales person asks you, “What brought you in here today?” And you respond “Looking for a new car, with an obvious look on your face.” “Oh” says the sales person, “Did yours die on you?” “No, you respond, it’s just time you know. I don’t want to hold on to it so long that it breaks down. I want to get something new now before it’s too late.”
Now think about this story, the car ran fine, it drove fine, it probably still looked fine, it was probably only 5-10 years old, but it was time for a new one. Things have improved in cars after all, better features, they are safer, more efficient, etc. and you want to make sure you’re in the best car for your needs. Why should investing be any different. Do you really want to hold investments because they are “just fine”? So, let’s spend a few minutes actually discussing the pros and cons of keeping and old 401(k) and you can determine for yourself and your situation if that makes the most sense.
Benefits of a QEP:
It goes without saying the most obvious benefits to a qualified employer plan (QEP) are during the active contribution stage, which is the time at which you are making weekly or bi-weekly contributions. First of all; you’re able to take advantage of the much large contribution limit than an IRA account. Plus, those dollars go in pre-tax saving you on federal income taxes during the year you contribute. Another huge benefit is the company match that makes it so irresistible, if the company in fact offers one. I mean who doesn’t love free money. In addition the contribution limit is much higher than in an IRA account allowing you to put more money away faster.
The next biggest benefit to a QEP is the simple investment choices. The plan gives you a menu of funds to choose from that they feel will do well for the collective group of employees. It is different in an IRA account. Typically, with most custodians you’re able to choose from nearly the entire investment world. Did you know that according to www.statista.com in 2019, there were 7,945 mutual funds in the United States, and that doesn’t even count individual stocks, ETF’s and alternative assets? I can see why now if you were responsible for picking the best ones yourself why you would like the limited selection of only a few average funds.
In conjunction with simple investment choices for most investors limited research is done or needed. If the fund has a decent 3-year, 5-year, and 10-year return, just go with that one. While that may be just find as we talked about earlier; don’t you want your money working as hard as you do?
Another perceived benefit of QEP’s is target date funds. What is better than picking your desired retirement date and letting them manage a fund specifically for those people wanting to retire at that year. The idea is to start with a larger percentage in equities and slowly reduce that over time in favor of more bonds. With target date funds you get simplicity, if that is what you are looking for.
Lastly one of the most valuable benefits of a QEP is loan provisions. The ability to borrow money from your QEP without incurring a taxable event and then be able to pay that money back and all the interest you paid was to yourself, is a substantial benefit to those with limited resources. If nearly your entire life savings is all wrapped up in this one QEP and you have limited liquidity for emergencies, you may find great value in this provision. If, however you have an emergency account, extra accounts for liquidity, and the ability to tap into other resources, this one benefit alone may not be worth staying in the plan.
Disadvantages of Staying in An Old QEP
We have talked about most of these so far but in a different light. Just as it may be a benefit to some to have a limited fund menu, it may be hurting your overall goals. Is it possible that there are better funds out on the open market that will achieve your goals faster with less volatility? Consider this; one of the best advantages to leaving a 401k() is the ability to pick your own investments like; individual stocks, ETF’s REITs, Options, and even crypto-currencies. These more specific investments may help you achieve your goals more efficiently over time.
A key disadvantage of the 401(k) is the overuse of target date funds. As stated before, the idea is simple enough but in practice you may not be getting what you were hoping for. The reality is that target date funds will often underperform in good markets and do a poor job of managing downside risk during tough markets. One of the reasons for that is the inability to reduce systemic risk. According to Morningstar analyst Jeffrey Holt in March 2018…
“In the long run, the biggest risk in target-date funds is that they won’t meet
investor expectations for avoiding losses.”
For more information on target date funds, I encourage you to read our partner blog post on the topic “Are Target Date Funds Good Or Bad?”.
Many people believer that because they don’t see fees listed on the statement 401(k)’s don’t have fees. Just because they are not listed doesn’t mean your not paying them. One of the greatest challenges participants face is picking 401(k) funds that have low fees. ERISA has tried to make things more transparent but many participants are still left in the dark.
Lastly because of the lack of investment choices, the push towards a one size fits all target date fund, and hidden fees; it is possible that that staying in a QEP may actually be hurting your performance long term. If you would like to know if you are maximizing your dollars to their fullest potential let us know and we would be happy to give you and your QEP a financial checkup. Click here to schedule a meeting to talk.
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If you’re confused by your 401(k) plan, you aren’t alone. According to a J.P. Morgan 2021 Defined Contribution Plan Participant Survey, 401(k) investors are “overwhelmed and unsure about the various aspects of retirement planning.”¹ In fact, 52% feel they are presented with more plan information than they can absorb.² Perhaps this is why 51% of 401(k) participants do not take time to read all the investment information provided by the plan.³ 401(k) plans may be confusing, especially when you’re presented with a packet written in industry jargon and told to hurry up and make a decision about your financial future. Understanding exactly what you’re enrolled in and why can be as easy as asking these 5 questions of your HR department or plan provider. Read More...
Let's talk about income sources. Which ones are the most tax efficient and as a bonus a few inefficient tax strategies just to be aware of. For the purpose of today's discussion we are not going to bring wages into play here. We are talking strictly about investment income sources. Income Source #1 ROTH IRA Income is the first and most obvious choice here. The benefit of the ROTH IRA if your not aware, (which is okay if your not - we are all about education here) is that you put your money in after you have already paid taxes but anything in the account grows tax free and can be taken out tax free in retirement. There are some nuances you have to be aware of like you must wait to take your distribution until you have had the account for 5 years you must be 59.5 years old but there are also some nuance early allowances like access to your principle portion at any time. But when it comes down to the general tax fee income it is really hard to beat the benefits of a ROTH IRA . We can discuss future pro and cons at another time. Income Source #2 Dividends Stock Income can be a very tax efficient income source for a lot of people. Now to offer some clarity here we are only talking about dividend income from stocks not held in any type of IRA or other qualified plan. The big advantage here is that "qualified dividends" are taxed at Long Term Capital Gains Rates which if you read our blog-post on that HER E , you would know have some major tax advantages. For Single filers you would pay 0% from $0 to $40,000 of income. You would pay 15% from $40,001 to $441,450 and 20% from $441,451 or more. For married filers you would pay 0% from $0 to $80,000 of income. You would pay 15% from $80,001 to $496,600 and 20% from $496,601 or more. As an example a married couple with $170k in income would be in the 24% tax bracket normally but in the 15% bracket on their dividends that were qualified . That is a pretty hefty amount of income taxed at very low rates. It is important to realize this style of investing does carry market risk and you will want to make sure this fits your overall goals and risk tolerance before diving in. Income Source #3 Real Estate Income can offer some wonderful tax advantages. Investing directly in rental real estate is a great way to leverage your wealth and get tax advantaged income but with prices at record highs this may not be the best time for that. The easiest way to invest in real estate is through publicly traded REIT funds that trade on the stock market. The main disadvantage of these types of holdings is volatility. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you are trying to achieve with this type of investment. Instead, consider looking into non publicly traded REITS. They often have a much lower correlation to the stock market as they are not traded like stocks. They get most of their value from the underlying real estate itself and not stock market share prices. But what about the tax advantaged income? The main advantage to rental real estate income is passthrough depreciation. That depreciation is given back to you as a tax deduction in the form of "Return of investment capital", meaning that portion of your income isn't really taxed right now. So lets say you got $20,000 a year in rental income but had $15,000 in depreciation or "Return of investment capital" that would mean you are only paying taxes on $5,000 of income on a $20,000 income source. How great is that. But there is a downside too. That depreciation lowers your cost basis which can increase your long term capital gains taxes if not planned for as part of your overall financial plan. If you want to talk about if real estate makes sense for you click below to schedule a time to chat. Income Source #4 Life Insurance holds many unique tax advantages. Much like the ROTH IRA you put those dollars in after tax. Like a ROTH it grows tax deferred and the distributions can also be tax free just like a ROTH but that is where the similarities stop. Unlike a ROTH there are no contribution limits or age restrictions or holding requirements. Some types even protect your cash value from loss while others are directly invested in the stock market. From a tax perspective here is what makes this strategy so unique. We already talked about distributions being tax free but did you know when you borrow money from your life insurance as income the income you take could still earn interest??? Since it is being taken out as a loan against the account the money stays invested. If you earn an average return of say 7% but only pay 4-5% in interest you are actually making 2-3% a year on income you already took out of your account. How great is that. That is called positive arbitration. The best part is your income is tax free and when you die your beneficiaries also get the remaining balance tax free as well. Income Source #5 Social Security Income can be one of the most tax efficient sources of income in retirement. If you have ever attended one our classes on Social Security planning you may know some of this already but for those that haven't or need a recap lets dive in. Social security can be anywhere between 0% taxable all the way up to 85% taxable. But the unique thing is that social security is never 100% taxable. So at now point will 100% of your check count towards you adjusted gross income for tax purposes. How cool is that. Now how much if it that is taxed is based on provision income. If you missed last weeks video on that click HERE . But basically the lower we can get your provisional income the less taxes you pay on your Social Security which could end up being a big deal long term. These are some of the most tax efficient income sources and when planned for properly you could very well live your life free of the burden of the tax man . However, there are few sources that are not so tax efficient. Not so efficient income Sources IRA/401k Income - Yes you are reading this correctly because IRA dollars are pretax, they have never been taxed before meaning that it is very likely that 100% of that income source is taxed at your federal tax rate. Really the only way to get around this is to fall into the 0% tax bracket which may be hard for many Americans. But don't loose hope just yet. If you have IRAs/401ks talk to us about how advanced planning may help get you to that 0% or 12% rate even with an IRA/401k. Mutual Funds - One of the reasons mutual funds are so tax inefficient is because of internal turn over ratio and what I call phantom income tax. Basically if you own a mutual fund and it sells some of the holdings within the fund at a profit throughout the year you are liable for the taxes on that gain even though you didn't directly sell anything yourself. Believe it or not this can cause unintended consequences like putting you in a higher tax bracket affecting your Social Security income, IRA income etc. Certain ETF's - Certain ETF's also fall pray to this phantom income tax and may have the same unintended consequences. So can you, or should you utilize any of these top 5 Most Tax Efficient Income Sources? I hope this helps making that decision but if you still need helping figuring things out, click the button below to schedule a time to talk.