A friend e-mailed me last week asking about her 401k options. She left her former employer, but also left her 401k plan with them. She was wondering if she should roll the old account over into an account with her new employer.

I let her know that while that is definitely an option, she may be wiser to move the money into a seperate IRA account. When done correctly, an “IRA rollover” has no penalities and no tax implications. In addition to the tax benefits, I have a three reasons why I prefer this option over moving to the new employer.

1. 401k plans are limited

Most 401k plans offer an average of 25 investment choices. This is true of my employer’s plan. Whether you are an active or passive investor, only 25 options can limit your diversification. Plus its difficult to know why these investments have been chosen for your firm’s employees. I’m not sure if my employer examined expense ratios when deciding on the funds to offer me or if they just picked the recommended options suggested by the brokerage firm.

 In an IRA plan you have almost unlimited options. I like to choose individuals stocks, ETFs, and mutual funds to create my own diverse account. I am an active investor and enjoy the control I can excerise over the account. I initially started as a passive investor, choosing a couple of mutual funds and just leaving the investment alone. I like that the IRA plan gives me both options.

2. All my money can be together

 Its very normal to change jobs every couple of years nowadays. For friends that plan on taking that route, I tell them to open a 401K at each new employer, but instead of rolling it along from one employer’s plan to another, I advise putting the funds from a past emplyer into one IRA account. This way, all funds from old employers will be in one place.

I view this as a better method to capturing long term returns because the money will only be cashed out from the 401k plan once or not at all. The 401K to IRA option allows for a whole investment portfolio to be moved without cashing out. When jumping from one 401k plan to another, the money must be cashed out everytime because its likely the new employer has a different set of investment options. This can have a large impact on gains/losses.

3. Roth funds can remain Roth funds

My employer offers a Roth 401K account in addition to a traditional 401K. I would hate to see anyone who took advantage of the Roth 401k move to an employer that doesn’t offer one and have to lose out on the tax benefit of that decision by converting funds to a traditional 401K. The great thing about IRAs, is that Roth 401K funds can be moved to a Roth IRA without losing the tax benefit (same goes for traditional).

What’s even better is that there is no limitation preventing me from having both a Roth IRA and a Traditional IRA (I have both). So according to whatever type of 401K plan I had at a previous employer, I can just deposit the funds into the corresponding IRA plan.

I hope this post will aid my friend in her decision making process. As for the logistics of the rollover, any full service or discount broker will be happy to help. They are usually so excited you want to move your money, so they try to make the process as painless as possible. Also, the IRS has a rollover chart on their website as a guide (though I find it a bit confusing).  If anyone has any follow up questions, I’m here to help.

Related posts:

1. Traditional vs Roth IRA Accounts
2. Help! My 401(k)/403(b) is plummetting!
3. Calculating 401(k) or 403(b) Contributions

A reader wrote in about the benefits of investing in stable income funds. These types of funds have risk and return a little higher than your average money market fund. The fund’s goal is to maintain the principle of your investment at $1.00, no more, no less.

How does this help me?

In company sponsored 401(k) or 403(b) plans, the employee’s contributions are directly invested into a series of funds, resulting in no option to have a portion of the funds sit in a savings or money market account. A stable income fund your solution to this limitation.

If you are actively watching the market, and feel that it will continue to decline, re-allocating your 401(k) contributions to include a stable income fund may be a good idea for you. I have checked the account from my company which is held at Fidelity. It has an investment called “FIDELITY MIP II CL 3″ under the fixed income/managed income category.  Considering the course of the market so far this year, I wish I have moved all of my 401(k) contributions into this fund in January. I can’t change the past, but I do have control over my future investments. I have changed the allocations I had previously set up for my account to now have 40% of my contributions go into this fund.

Later, when I feel the market is going upward, I’ll re-allocate my future contributions to reduce or eliminate adding to the stable income fund. I will also consider selling out wholly or partially from this fund and buying into the funds that are attractive at that point.

I’m not suggesting you follow in my footsteps, only trying to make you aware of this option. You should never feel like you have no control over a company sponsored retirement plan. It has many limitations, but together we’ll work around them.

Thanks to the reader who wrote in about stable income funds. Keep the comments coming!

UPDATE: On 12/15/08, I have reduced the 40% election to only 10% in order to take advantage of the lower prices in the current market. I will continue having 10% of my future contributions go into this stable value fund.

Related posts:

1. Calculating 401(k) or 403(b) Contributions
2. Left your employer without taking your 401K?
3. Traditional vs Roth IRA Accounts

Tax the seed or Tax the Tree?

We have already discussed the path to future financial independence involves starting to save early. The first action is to invest in a company 401(k) or 403(b) plan up to the point of the match. I’ve explained this process already in my Calculating Contributions post.

The next thing to do is take advantage of an IRA account. There are two main types of IRA accounts, a Traditional IRA and a Roth IRA. For the 2008 tax year, both types of accounts allow contributions up to $5,000.

Why the IRA over the 401(k)?

Before diving into the two types of IRA accounts, I want to clear up the reason for utilizing an IRA account instead of increasing 401(k) or 403(b) contributions. A typical company’s 401(k) account allows for employees to choose from 17 investment options. I double checked my company’s plan held at Fidelity, and it limits me to 25 investment funds. These few options have to cover many asset allocation classes: large-cap, small-cap, emerging markets, bonds, target retirement, etc. This means there are 2-3 funds for each category at most, and that’s not much to pick from.

IRA accounts help overcome these limitations by allowing almost any type of investments. Passive investors can choose a couple of mutual funds or ETFs, while active investors can choose individual equities, create bond ladders, and even write call options.

Which type of IRA account to choose?

Let’s first discuss the differences between the two accounts. The income limitations for a traditional IRA account may prevent this type of account from even being an option for some people. The table below shows all values that apply to someone that is single. For those who are married filing jointly just double all numbers and for anyone else, the source for the table below is an IRS news release that shares additional info:

So What’s the Difference?

Short Answer: Nothing, that is if your tax rate never changes.

Long Answer: Your current vs. future tax rate decides which option is better.

• Higher tax rate now than anticipated for the future – Traditional IRA (applies to very few people)
• Lower tax rate now than anticipated for the future – Roth IRA

For anyone interested in a complicated number crunching exercise that shows the exact difference between the two accounts lies in your tax rate, go here.

Related posts:

1. Left your employer without taking your 401K?
2. Help! My 401(k)/403(b) is plummetting!

Be a DIYer when it comes to Financial Planning

This blog was intended to be about figuring out what to do with money after earning it. The idea is to work for money now so one day money will work for us. Naturally that can lead to questions about retirement preparation and the infamous 401(k) or 403(b) plans offered in many workplaces.

I am not a financial adviser or an investment professional. All I can do is share my strategy for success.

Many companies offer a 401(k) or 403(b) plan as a benefit to their employees. For those who are familiar with 401(k) plans as being a retirement savings plans, a 403(b) is a similar plan offered to employees of educational institutions and non-profit organizations. Both have the benefit of deferring taxes until withdrawal.

If your company offers the opportunity to invest in a 401(k) or 403(b), ALWAYS ALWAYS ALWAYS take advantage. Many companies match your contributions, usually up to a certain dollar amount or percentage. This is where contributing gets confusing.

• First, find out the point of maximum company match.
• Second, contribute! If the match is a percentage of salary, contribute that percentage per paycheck to the account.
• There are few opportunities for FREE MONEY and this is one of them!

How Do You Calculate the Match?

Let’s use an example to walk through the average company match. Let’s say your company matches 50% ($.50 per $1.00) of the first 6% contributed. If your salary is $52,000 and you get paid bi-weekly, your paychecks are $2,000 (before taxes).

You should set your contributions to be exactly 6% of your salary, or $120 per paycheck. At this level your company will contribute of $60 of their money to your account. So you don’t have to pay taxes on $120 of your income each pay period and your account grows by $180 at the same time.

If 6% seems like too much to contribute at one time, try to ease yourself into it. Start at a point you feel comfortable with, like 3% and try to increase it by 1% each quarter until you reach the max point. Don’t feel pressured to contribute more than the matching level. Alternative options to a 401(k) or 403(b) plan will be presented in future posts.

Related posts:

1. Help! My 401(k)/403(b) is plummetting!
2. Left your employer without taking your 401K?