Reader Questions Josh on 05 Feb 2009 04:17 am
Open Mic: Question From a Reader
If this is your first time visiting Centsability to Wealth you may want to see what we are about or read our introductory post.
This weeks Open Mic question comes from 28 year old Suzy Edwards in San Francisco, California.
After recently switching jobs, I was surprised to find out I had about $6,000 sitting in my 401 (k) with my former employer. I am having trouble figuring what I can and should do with this money. Can I just leave it there? If so, should I leave it there?
I also have about $4,000 in credit card debt, which I could pay off if I simply cashed out my old 401 (k). Would this be a good idea? I know saving for retirement is important, but I also know how much you preach paying off debt. Since it is only $6,000 in the account anyway, I figure it would be better off getting rid of my expensive debt (15 percent interest rate).
What would you recommend, leaving the 401 (k) alone, or cash it out to pay off debt?
This is a great question, Suzy. And with the frequent amount of job changes people go through these days, it is one almost everyone will face multiple times in their working life. You mentioned two options for your problem, but there are actually three. Let’s go over all three and discuss which would be best for you.
Option 1: Leave 401 (k) with your former employer- Your first option to this situation is to simply let the $6,000 sit in your former employers 401 (k). If you pay very little attention to your 401 (k) (which I’m guessing is the case, since you say you were surprised to find out how much you have in there), this is a perfectly fine option. Your $6,000 will stay in whatever fund you have it in and continue to grow until you retire. The downside to this is that 401 (k)’s usually offer few investment options, but if you aren’t someone who actively follows your account this doesn’t matter to you.
Option 2: Cash out the 401 (k) to pay off debt- Your second option is to cash out the $6,000 from your 401 (k). First let’s look at the consequences for doing this. As a penalty for taking money out of your retirement account early, you will pay a ten percent penalty, which will take away $600 from your total amount. On top of that, since 401 (k) contributions are made pre-tax on the assumption you won’t take it out until retirement, you will now be forced to pay those taxes. Even if you are in just the 15 percent tax bracket, that will be an additional $900 off your total. You are now down to about $4,500 from the original $6,000. While still enough to pay off your $4,000 in credit card debt (and it is good you are concerned with this debt), you are essentially giving away $1,500.
Now let’s look at what would happen if you kept the $6,000 in a retirement account until you were 65. Since you are 28 years old now, that gives the money 37 years to grow. After those 37 years, assuming a very conservative 8 percent return, what you called “only $6,000″ has now turned into $103,473! That is the magic of compounding.
So basically, by cashing out your 401 (k) you will receive about $4,500 now while forfeiting $103,473 you could have at retirement. You are right, I do frequently preach paying off credit card debt. But sacrificing about $99,000 of return on investment in order to pay of $4,000 of credit card debt is just not a wise decision.
Option 3: Roll your 401 (k) over to an IRA- Your third option is to take the money from your 401 (k) and roll it over to an IRA (individual retirement account). There are no penalties to do this, and it offers a few benefits. First, an IRA will typically offer more investment options and lower fee’s than a 401 (k). Second, by rolling over to an IRA you will then be able to switch to a Roth IRA, which can be an excellent investment tool for some people.
To do this, you would simply call an investment company, Fidelity for example, and tell them you want to roll your 401 (k) over to one of their IRA’s and they will be more than happy to help you. One important thing to keep in mind with this, though, is that you do not cash out your old account before rolling it over. This will cause you all the penalties listed in option 2. Instead, you are doing a straight roll over from your old account to your new one.
Obviously, I am going to strongly recommend you not take option number two, cashing out the money. It would be flat out irresponsible to take that money out for anything short of an urgent emergency.
That leaves you the choice between leaving the 401 (k) alone, or rolling it over to an IRA. Judging from your email, I’m guessing you aren’t actively involved with the investments in your account. If this is the case, and you are not interested in switching to a Roth, I would suggest simply leaving your 401 (k) with your former employer. There is no need to go through the small hassle of rolling it over to an IRA if you aren’t interested in the benefits it would provide.
What advice would you give Suzy? What have you done with your retirement account when switching employers?
If you would like to be featured in a future addition of Open Mic, send your personal finance related question to centsabilitytowealth@gmail.com.
Technorati Tags: 401 (k), IRA, personal finance, Roth IRA, credit card debt, taxes
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