My Retirement Blog

I’ve left two jobs in the last five years and each time I rolled over my 401(k) into a Rollover IRA held at Vanguard. In both cases, I rolled over the IRA within a few months of departing my job and I did so for a small handful of reasons.

The number one reason for rolling over my 401(k) into a Vanguard Rollover IRA was simplicity. Why deal with yet another account accessed through yet another website, when I could integrate everything and deal with that account through a great brokerage such as Vanguard? I don’t need more fund balance mailings and fund performance reports, I need my life to be simpler so I can focus on the other things that matter. The end result was that I rolled both of my 401(k)’s into a single Vanguard account (and then I turned on electronic delivery of statements!).

The second reason was for diversification, which is related to simplicity. If I have to access two 401(k)’s in two accounts, it’s much harder for me to control the asset diversification because I couldn’t feasibly see two accounts at once and tweak them concurrently to get the right diversification. One of the 401(k) had some home-brew funds (not created by a major brokerage like Vanguard or Fidelity), so I couldn’t even be certain what the asset allocation within the fund itself was like. It was far easier to pull them all into Vanguard and break them up into Vanguard funds, though any major brokerage like T. Rowe or Fidelity would’ve sufficed as well (I chose Vanguard because I’ve had a long history with them and never been disappointed).

The third reason was cost. At Vanguard, I pay no account maintenance fees whatsoever. If you turn on electronic delivery, the administrative costs go down to $0 and are integrated into the expense ratios of each fund. The funds at Vanguard are much cheaper than the ones at either of my 401(k) plans, though some were pegged to the same benchmarks. Cheaper isn’t necessarily better, much like expensive isn’t necessarily better, but Vanguard has a solid performance record and cost is something I can control.

One account instead of three, an accurate picture of diversification, and controlling the one aspect of mutual fund investing I can control (cost), were the reasons I rolled over my 401(k)’s to a Rollover IRA.

You may have heard about the Roth 401(k) and the Roth IRA and wondered, what is the difference and why is this guy Roth putting his name on everything? To be fair, the guy Roth was Former Sen. William V. Roth Jr. (he passed away in late 2007) and he was the man most responsible for the original Roth IRA. The Roth 401(k) was merely taking the Roth IRA and applying it to the 401(k), thus creating a regular/traditional 401(k) and a new Roth 401(k).

The Roth 401(k) works like the Roth IRA, your contributions are post-tax and your disbursements are tax free. You can take early payments but you pay taxes on the proportion of the withdrawal that is “appreciation” equal to 10% plus your marginal tax rate.

Contribution Limits

The contribution limit is $15,500 for those under 50, with an additional $5,000 catch-up addition for those over 50, in 2008. This contribution limit is shared between the regular 401(k) and the Roth 401(k), which means the sum total of contributions to both plans cannot exceed the annual limit of $15,500 or $20,500. Another wrinkle to the rule, that is often never an issue, is that the sum of employee and employer contributions have to be less than the employee’s total salary or $46,000, which ever is smaller. (another wrinkle is that employer contributions are pre-tax, so they sit in the traditional 401(k))

Rolling Over

When you leave your employer, you can roll over your Roth 401(k) into a Roth IRA just as you would a 401(k) into a Traditional IRA.

Of my two former employers, only one had instituted the Roth 401(k) so adoption has been slow. Most employers don’t want the added administrative burden of operating yet another defined contribution plan.

For 2008, the Highly Compensated Employee income level was increased from $100,000 to $105,000. If your income is above $105,000 then you are considered “highly compensated” for the purposes of retirement plans. If you are curious as to the rules regarding HCE’s, please read this page that discusses what a highly compensated employee means.

I’ve rolled over two 401(k)’s into a Rollover IRA at Vanguard and both times the process was absolutely painless. If you’re thinking about taking advantage of Vanguard’s low fee index funds, and other mutual funds, then I think that rolling over a 401(k) is a great way to do it. The process is pretty easy and similar to rolling over to anywhere else.

First, you’ll need to open an account at Vanguard.com, specifically you’ll want this page because it focuses on moving money to Vanguard. If you run into any trouble, you can always call up their retirement specialists at 800-414-1742 and get to a human being in a few minutes. After you follow those instructions, you’ll need to contact your current 401(k) custodian (brokerage firm) to let them know you intend to perform a trustee-to-trustee rollover.

The name you want the check made out to is Vanguard FTC and then have the check mailed either to you, where you will forward it to Vanguard, or directly to Vanguard. The information that is provided to you from Vanguard’s online form should tell you where everything should be sent.

If you already have a Rollover IRA at Vanguard, simply do everything as you did before and include a letter that instructs them on how to divide up the funds. The letter is simple, just write that you want a certain dollar amount or percentage in which funds and you’re all done.

As easy as it should always be. (I don’t know if any other brokerage is easier or harder, I just know that Vanguard’s never been a problem)

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The 150th Carnival of Personal Finance is up!

The latest Yahoo Finance article on retirement, courtesy of TheStreet, is one in which they discuss managing two 401(k)s when both members of a marriage are working. The article itself is merely an extension on the discussion of one’s own diversification in a single 401(k) but I think there are some points that it could’ve made but didn’t.

Here are some points it did make that are worth noting:

• Some 401(k)s have better funds for different things. For example, a small cap fund in one 401(k) may have a better expense ratio than the small cap fund in the other 401(k).
• One 401(k) may offer options not available in another fund, such as emerging market funds. This would allow you to have some diversification by way of emerging markets through one 401(k) and then balancing that out in the other 401(k).
• If your total retirement contributions won’t max out both 401(k), max out the one that’s more beneficial to your family. Go for the ones with better employer contributions, better funds, etc.

Some points that it missed:

• Having two funds makes management much easier, you can have one account focus on one asset type (preferably the one with better fees) and then re-balance with the other. For example, put all of the funds in one 401(k) into large cap equities and then use the other 401(k) to go international and emerging markets.
• Two accounts means greater discussion, talking about retirement and money is always a good thing.

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MoneyNing did a fine job on the Carnival of Personal Finance this week and My Retirement Blog was included with our post Retirement fund or emergency fund?

In all the discussion about retirement plans, pensions, 401(k)s, IRAs, you may have heard the term “defined-benefit” and “defined-contribution” plan thrown around and wondered what they meant. Both are employer-sponsored retirement plan types but have slight different characteristics.

Defined-Benefit Plan
A defined benefit plan, often called a “qualified benefit plan” or “non-qualified benefit plan,” is an employer sponsored retirement plan where an employee’s benefits are calculated based on an equation using employee factors, such as one’s salary history and length of employment. Under these plans, all the management functions of the plan are handled by the company and they alone bear the risk of their decisions; employees simply get paid out according to the schedule of the agreement.

(In the case of qualified benefit plans, the qualified refer to tax-qualified and the difference is that those plans have added tax incentives. Non-qualified benefit plans do not get these tax incentives)

Pensions are a common form of defined-benefit plan. Many pension equations include a growth rate tied to the results of the investments decisions made by the plan, but if the decisions result in negative results you will often see companies dip into earnings to fund pension shortfalls.

Defined-Contribution Plan
Whereas a defined benefit plan defines the benefit an employee receives, through a calculated equation, a defined-contribution plan only defines the front side of that equation. It’s an employer sponsored plan in which a specified amount or percentage is set aside for an employee. In these plans, the investment decisions may or may not rest in the hands of employees.

401(k) and 403(b) plans are common forms of defined-contribution plan. With a 401(k), your employer agrees to match your contributions up to a certain amount or simply contribute a percentage of your salary each year. In the case of many 401(k)s and 403(b)s, investment decisions and risks are for the employee to make and bear.

401(k)’s are a great retirement investment vehicle. The two primary benefits of a 401(k) is that your employer will often give you some sort of small percentage match on your contribution and you get an immediate tax deduction for the amount you contribute. When your employer kicks in an employer match, that’s like automatic appreciation. To leave that on the table would be a huge mistake. The immediate tax deduction is also a plus because it softens the blow of not being able to access the funds and it’s a “reward” for thinking of the future.

There is just one huge problem with 401(k)’s: you are always taxed the short term capital gains rate.

Let me illustrate with an example. If you purchase a share of MRB Enterprises at $10 a share and it appreciates to $20 a share within a week, you may consider selling it. If you sell it within a week, the gains are taxed at the short term capital gains rate (your marginal tax rate). If MRB Enterprises stays at $20 for another year (51 weeks and a day), then you qualify for long term capital gains tax rates which are 10% or 15%, depending on your marginal tax rate. The difference between short term and long term capital gains can be staggering (the maximum individual income tax rate is 35%).

When you take disbursements from a 401(k), you’re taxed at your marginal tax rate no matter what. If you held an index fund within your account for the last forty years and start taking disbursements, you will be taxed not by the long term capital gains rate but instead by your short term capital gains rate.

I’m not mentioning this because I think it’s unfair, it’s totally fair; but it’s food for thought.

I’m a fan of flexibility and I like having my options as wide open as possible. That’s why I don’t like rolling over a 401(k) into another 401(k).

After leaving my first job, I immediately rolled my 401(k) into a Vanguard mutual fund account. I felt that Vanguard would give me plenty of options while keeping my costs low. If you elect for electronic delivery of prospectuses and statements, you will pay little to nothing in administration fees. With the costs low from the fee perspective, I felt I had enough options to choose from in the funds department (and they are cheap!).

What happens if you roll it over into a new employer’s 401(k)? You have a smaller subset of options (some plan administrators are larger brokerages like T. Rowe Price), higher fees, and your money is essentially trapped there until you leave your job and roll it over again.

So, before you roll your 401(k) into yet another 401(k), think carefully about it… you might find a better option.

When you leave a job, you will be confronted with a decision. If you had a 401k, you will have to decide whether you will keep it with the current plan administrator, roll it over into your new employer (if they offer a 401k), roll it over into a Traditional IRA, or cash it out. Each has its benefits and drawbacks but ultimately the worst of them all, in terms of long term sustainability, has to be the cash it out option.

If you cash out your 401k, not only are the taxes due immediately but you also take a 10% penalty. So, if you had $10,000 and are in the 25% tax bracket, you will only get $6,500 of your hard earned money. That’s right, of the $10,000 you rightfully earned, you will get only $6,500 of it!

But I’m in a tight financial situation! If you are in a tight financial situation, see if you can simply borrow from the 401k or qualify for a penalty free withdrawal. Borrowing is only allowed if your plan administrator allows it, please check with them for the specifics. Penalty free withdrawals are decided by the IRS and they cover situations where you become disabled, have significant medical expenses (expenses exceeding 7.5% of your AGI), have been ordered by the courts to pay up money, etc. You can find a list by doing a simple google search on 401k withdrawals.

Don’t accidentally cash out! If you decide to roll your 401k over into a Traditional IRA, you have two options. The first is a “trustee to trustee rollover” (or “direct rollover”) where the check is written directly to the new administrator. The second is where the check is made out to you and you have 30 days to deposit it into the new plan’s account. I always go with the first option. You never know what will happen and so you never want to tempt yourself with that kind of money. Life happens and you don’t want to have to deal with any issues that result.

Retirement is precious, don’t screw it up! The process is easy as long as you follow some simple rules, don’t screw it up by getting greedy and cashing out. Paying someone 10% to get your own money is ridiculous.

On my mainstream personal finance blog, Blueprint for Financial Prosperity, I penned an article today called How To Become A Millionaire (In 6 Easy Steps!) that begins with a two steps focused solely on retirement. For the retirement saving savvy out there, these two steps are obvious and a staple of retirement planning. Step 1 is to contribute to your company’s 401(k) plan and, hopefully, get yourself a nice employer match for your efforts. Step 2 involves contributing towards a Roth IRA so that you can diversify your tax profile, a little of tax-deferred to go with your tax-free retirement investments.

Becoming a millionaire isn’t difficult but it does require discipline. It’s extremely difficult to take some of your hard earned money and lock it up in a time capsule you won’t open for twenty, thirty, or forty years. It’s even harder if you have current financial demands such as children, bills, etc that are vying for your next dollar. If you have the discipline to do it, you should be handsomely rewarded with a more fulfilling retirement.