The worst thing you can do with your 401(k) when you leave a job, according to a financial expert and bestselling author
- Ramit Sethi is the author of the New York Times bestseller, "I Will Teach You To Be Rich."
- In the latest edition of his book, Sethi says the worst thing anyone can do when they leave a job is cash out their 401(k).
- The best thing to do with an old 401(k) is roll the money into a traditional IRA or Roth IRA, which provides a lot more investment options.
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There's one major workplace benefit that anyone leaving a job can, and should, take with them: their 401(k).
Writing in the latest edition of his bestselling book "I Will Teach You To Be Rich," financial expert Ramit Sethi says there are two smart ways to handle retirement savings invested in a 401(k) when you leave a job: roll the money into an IRA or roll the money into your new company's 401(k).
The one thing you definitely shouldn't do with your 401(k)? Cash out. "This is the worst thing you could possibly do," Sethi wrote, citing a statistic that more than half of 20-somethings make this mistake when switching jobs.
The 401(k) plan is the most common type of employer-sponsored defined contribution plan - i.e. non-pension plan - in the US, according to the Investment Company Institute. About 55 million Americans contribute to a 401(k) plan at work, which allows employees to make automatic salary deferrals, either as a percentage or dollar amount, directly into an investment account.
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The money you contribute to a 401(k) is yours to keep, but the IRS imposes strict distribution rules because of the preferential tax treatment. Withdrawing any of the money in a 401(k) before age 59 and a half would make it subject to ordinary income taxes, plus a 10% penalty.
The much better option, according to Sethi, is to roll your 401(k) into a traditional IRA or Roth IRA when you leave a job. An IRA is a type of a tax-advantaged investment account you can open on your own at almost any financial institution. Both IRAs and Roth IRAs offer a ton of investment options, including a wide variety of stocks, bonds, mutual funds (including index funds), exchange-traded funds (ETFs), and certificates of deposit (CDs).
You can also transfer your 401(k) from your old company to your new one, if it offers a 401(k), but there are some limitations to consider, Sethi said.
"The main reason to contribute to a 401(k) is to take advantage of your employer's match, which won't apply to funds you roll into the new account," he wrote. In addition, while your new company may offer different investments in its 401(k) than your previous company, it will still be a limited selection compared to what's available in an IRA.
The bottom line: Don't neglect your 401(k). It's an invaluable investment tool that makes saving for retirement virtually effortless.
- Read more about 401(k)s and IRAs:
- How to open an IRA
- How to invest in a 401(k)
- How to rollover a 401(k)
- How to invest in a Roth IRA
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