Don’t Leave an ‘Orphan 401(k)’ Sitting Around

If you have an orphan 401(k) from a previous job, learn your options for making the best use of it for your financial future.

Are You Making the Most of Retirement Accounts from Previous Jobs?

Changing jobs is sometimes the best way to climb the ladder and achieve your career and financial goals, and it’s something that the average American will do about five times these days. However, there’s a lot of administrative work and paperwork that goes along with any job change, and it’s easy for retirement planning to slip through the cracks. One of the key things to tackle when you’re changing jobs is to make sure you don’t leave an ‘orphan 401(k)’ sitting around with unrealized potential.

An orphan 401(k) essentially refers to a retirement plan that former employees have forgotten about or abandoned when moving on to a new employer. When it comes to building up a retirement nest egg, investing in your 401(k) is one of the best ways to save, so it’s crucial that you don’t just leave that account hanging in limbo. It can be difficult to navigate what to do with your orphan 401(k) when your new employer is offering a new one for you to contribute to, but these steps can help you ensure that you’re maximizing your savings in the best way possible.

Basically, you have four options for making use of an orphan 401(k). Each option comes with its own list of pros and cons, but here are the main takeaways to help you make a better choice for which option is best for you.

Option 1: Cashing Out Your Orphan 401(k)

When looking at all the ways you can handle an orphan 401(k), it can be tempting to cash yours out and be done with it. However, though this may seem like the least stressful option, it isn’t necessarily the smartest financial choice because you face a financial penalty when you cash out a 401(k) before the age of 59 ½. You’ll also have to pay federal and state income taxes. Once you add all the fees and charges together, you could risk losing up to 40% of your investment.

SEE ALSO: Everything You Need to Know About 401(k) Rollovers

Option 2: Leave Your Orphan 401(k) with Your Old Employer

Leaving your orphan 401(k) with your previous employer is another option you might consider because it’s simple and stress-free. However, it comes with a few drawbacks.

To begin with, you’ll no longer be able to contribute any money to this plan, so if you want to keep investing, you’ll have to enroll in your new company’s 401(k) plan to continue building your retirement nest egg. That means you’ll be required to manage two 401(k) accounts simultaneously, each with its own requirements and statements. So, while this option may seem simple at first, it can become more complicated for you down the road.

Additionally, now that you’re no longer an employee with your previous employer, you’re most likely going to be charged a higher administration fee for your orphan 401(k) plan. There’s also a good chance you’ll have to pay service and maintenance fees, which can significantly eat into your savings over time. If your 401(k)-account balance is below $5,000 your orphan 401(k) plan administrator can force your assets out of the plan and roll it over into a self-directed IRA.

Even with these drawbacks, leaving your 401(k) with your old employer may be the best choice if that employer offers company investment options that you really like, or if they provide access to professional guidance that you can take advantage of.

Option 3: Rolling Your Orphan 401(k) into Your New Employer’s Plan

If you’re deciding whether to leave your orphan 401(k) with your previous employer or bring it with you to your new employer, rolling it over tends to be the better option for most people. Not only does it give you better control over your investments, but it consolidates everything, so you’ll only have one account to manage.

Still, that doesn’t mean this option is the best choice for you. Typically, new employees have a waiting period before they’re able to enroll and contribute to a new 401(k), so your investments will have to be put on hold. Also, 401(k) accounts don’t necessarily offer you many opportunities to customize your asset allocation as they typically come with limited investment opportunities.

So, if you’re thinking about combining your orphan 401(k) with your new plan, be sure to investigate what your new employer’s 401(k) offerings are to see if the benefits are worth it.

SEE ALSO: Young Investors: Roth IRA or Traditional IRA?

Option 4: Rolling Over Your Orphan 401(k) into an IRA

The last option we’ll discuss is typically the best option for most people when it comes to handling an orphan 401(k). There are many benefits to this option, but one of the most significant is that you’re given more freedom and investment options since you’ll no longer be restricted by your previous employers’ rules regarding where, how, and when you can invest your funds. Additionally, there’s no waiting period, so you’ll be able to contribute to your IRA immediately.

Despite this freedom, there are a few drawbacks to be aware of. Depending on the structure of your account, you could incur higher fees than you would with an employer 401(k) so you’ll want to do some research to be sure that the benefits will outweigh whatever costs you’ll have. There’s also an annual contribution limit that you’ll have to be aware of. For 2023, the limit is $6,500 for anyone under the age of 50 and $7,500 for those over the age of 50.

Choosing the Best IRA for You

If you choose this option, you’ll have to decide whether you want to convert your orphan 401(k) to a Roth IRA or a Traditional IRA. The main factor differentiating these two accounts is the tax advantages they offer. For a Roth IRA, your investments are taxed at the time of contribution, but you can withdraw your funds tax-free. Traditional IRAs work in the opposite way; you contribute money tax-free, but then you are taxed on your withdrawals.

As you decide, be sure to factor in any management fees and transaction costs. Look to see whether there are any sales commissions or other fees at play as those may make one option significantly better than the other. Also, if your orphan 401(k) was funded with pre-tax contributions and you want to roll over those contributions into a Roth IRA you will face income taxes to convert pre-tax dollars into post-tax dollars.

Final Thoughts on How to Handle Your Orphan 401(k)

With most things in finances, there’s no one-size-fits-all strategy for you to follow. Deciding which option is best for your orphan 401(k) will be up to your personal circumstances and financial situation. What’s important is that you do your due diligence in researching all the benefits and drawbacks so that you can have confidence in knowing you made the right choice.

If you’re feeling overwhelmed with making a decision, it can help to talk to an investment advisor who can walk you through each option and work with you to determine which is best for your overall financial strategy. At Davidson Capital Management, we offer personalized investment management services to help you create a comprehensive investment plan that empowers you to achieve your short- and long-term goals. If you’d like to schedule a conversation with one of our advisors, please reach out to us today.