It can be confusing trying to figure out what to do with your retirement funds when you switch jobs considering there are a variety of options.
If you’re not careful, you can make choices that will seriously hinder your nest egg, which in turn can hinder the quality of your retirement years.
To avoid that unpalatable outcome, here are five tips that will ensure that you make the best decisions with your rollover IRA.
#1: Don’t Take a Cash Payout
Before you even set up your rollover IRA, you can drop the ball if you’re not careful.
When you leave an employer, you have several options — you can leave your money in their retirement plan, you can receive it as cash or you can move that money over into a rollover IRA at a new custodian.
Of these options, the first is sub-par, the second is really bad and the third is best.
If you leave your money in your former employer’s plan, you still have access to the same investments you had before … but you have less flexibility in a 401k than you do in your own IRA. Also, many people tend to forget about financial assets from previous employers.
Out of sight, out of mind.
The worst option, however, is taking a check from the old plan. When you cash out of a 401k, administrators typically automatically withhold 20% of your balance for tax purposes, and if you’re younger than 59 1/2, you incur an additional 10% penalty for early withdrawal. How much you’ll actually owe in taxes depends on your income level and state of residence, but count on taking a big hit.
That’s a double whammy of a big tax hit, and a huge cramp on your ability to make your retirement dollars compound.
Thus, the best option is to set up the rollover IRA.
#2: Don’t Start Wildly Speculating
If you’ve had all your money in your 401k, managing a rollover IRA can be a daunting task. You now have far more investment options, and far fewer restrictions.
Sadly, some people use this newfound liberty to make very poor choices.
In a rollover IRA, you have the ability to buy individual stocks, speculate in commodities, bet against the market and other such options that were off limits in your 401k. There’s nothing wrong with taking more aggressive approaches if it suits your risk tolerance and investing goals. But don’t go crazy the moment you set up the rollover IRA. Take some time to figure out how you want to invest and what your risk thresholds are.
I’ve heard too many unfortunate stories about people having a pile of funds free up and turning into unchecked day traders. Unless you are sure you know what you’re doing, use moderation and a disciplined approach to investing your new rollover IRA funds.
#3: Watch Fees Carefully
If you invest in mutual funds or index funds, fees are quite possibly the most important factor for investment success. A large number of mutual funds produce returns more or less in line with the broader stock market. And index funds, by definition, are built to match the market.
As such, your rollover IRA is likely to get returns that are fairly similar to the market if you stick to typical funds and ETFs.
Perhaps the biggest difference you can make, then, is keeping an eye on the fees you pay.
If you choose a mutual fund with a 2% annual fee and it returns 6% a year, you’re losing a full third of your investment gains! By the time you hit retirement, that adds up to a huge loss of wealth. If you buy a fund that produces the same level of returns, but only charges 0.6% a year in fees, now you are only giving up 10% of your gains to your money manager.
The difference over years or decades can be tremendous. For instance, let’s take the examples above. Fund A charges 2% annually, while Fund B charges 0.6% annually. Both return 6% a year for the next 30 years. A $10,000 investment in Fund A would return $31,330 … but a $10,000 investment in Fund B would yield a whopping $47,948! That’s more than $16,000 lost between expenses and opportunity cost.
In the past, fees were mostly inescapable. And in a 401k, you were stuck paying for whatever your employer decided upon. But today, there are plenty of very low-cost alternatives for managing your money. If all else seems equal, go with the option that charges less in fees.
#4: Stay Diversified
As the manager of your rollover IRA, you now have the responsibility of managing your investment choices. In a 401k, you do have some power over asset allocation … but even the default option there was generally fairly diversified. In a rollover IRA, it’s hard to glide by with just a default selection.
You can get a one-stop solution by buying a target-date fund. These intend to select an intelligent package of stocks, bonds and other assets that gradually become more conservative as you get closer to retirement. These are available as both mutual funds and ETFs.
If you choose to pick individual funds or ETFs, you’ll want a balance between stocks and bonds, and between international and domestic. An extremely general recommendation would be 70/30 stocks and bonds, and 80/20 domestic/international. You’ll want more bonds and perhaps other income-generating assets such as REITs as you get closer to retirement, however.
And if you choose individual stocks, make sure to diversify broadly across sector, market cap and even geography. A portfolio of all Internet companies or small biotech firms might seem great when these sectors are hot. But in the long run, owning a broad cross-section of stocks across the entire economy generates better returns.
Don’t Panic
The biggest danger to investors is fear. During a stock market crash, it’s easy to panic and sell out of investments at the worst point. Similarly, it’s easy to sell winners after some modest gains.
You can always think of a reason to sell, really.
But overaction is the enemy of great long-term returns. As the manager of your rollover IRA, you need to make good decisions to ensure a prosperous retirement. Find good stocks or funds, keep fees low, then invest in them with confidence. Only sell when it seems like there’s no more upside to be had. Or lock in gains by setting higher stop-loss orders as your shares improve.
There are many different avenues to a great retirement portfolio. Make sure you understand what you’re buying, and don’t fret the day to day swings in the market. A rollover IRA gives you many more options than a 401k, and managed wisely, it is a cornerstone to a successful retirement plan.
You can reach the author on Twitter at @irbezek.
