In the ever-changing job market, you’ll likely switch jobs several times during your career. It’s also likely that some of these professional changes will involve deciding what to do with your 401(k). This may seem like a trivial matter, but how you treat this investment decision can have a major impact on your future finances.
When you switch jobs, you have several options for your 401(k) with your former employer. You can leave it where it is, take a lump sum distribution, roll it over to the 401(k) at your new employer or roll it into a traditional or Roth IRA. If it’s less than $1,000, your former employer might automatically cash it out and send you the funds.
Rolling your 401(k) into an IRA can open the door to a wider selection of investments and potentially lower fees, which is why it’s often recommended by financial advisors.
If you choose this method, you can request a direct or indirect rollover. If you choose a direct rollover, the 401(k) plan administrator will send a check directly to your IRA provider. If you choose an indirect rollover, you’ll receive a check from the 401(k) plan administrator and you’re then responsible for depositing it into your IRA.
In either case, it’s not typical for the trustee of an IRA to automatically invest your funds when you move funds into the account. This is where people often make a common mistake: not reinvesting their funds. Instead, they leave their funds in cash and earn a low return.
But you can avoid losing out on potential retirement earnings if you proactively plan your 401(k) transfer.
Time out of the market can be costly
By leaving your funds in cash, you’re missing out on the potential for substantial growth. Even if you leave the funds uninvested for a short time, you risk leaving money on the table if there’s a large market rally.
Calculations by Fidelity show that if you’d invested money in the S&P 500 index on Jan. 1, 1980, but took it out of the market on the five best days between then and the end of 2022, your return would be almost 38% less than if you had kept it invested. And Bank of America showed that for each decade from 1930 to 2020, missing the 10 best days for the S&P 500 index resulted in total returns being substantially lower.
But when people roll over funds from a 401(k) to an IRA, they don’t leave their money uninvested for just five or 10 days. A study by the Investment Company Institute found that for rollovers of accounts between $1,000 and $5,000, 43% were still invested in money market funds eight years after the rollover.
Similar calculations by Vanguard, looking at rollovers into Vanguard IRAs, found that the median time from the rollover to investing was nine months — and 28% of rollovers remained uninvested for at least seven years. Investors aged 20-29 and those with balances under $5,000 remained in cash longer.
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The solution: Don’t wait to invest your IRA
Vanguard suggests this problem could be solved by adopting a rule like the U.S. Department of Labor’s qualified default investment alternative (QDIA) rule for 401(k)s, where investors who don’t specify their investment preferences have their funds automatically allocated to certain acceptable QDIA investment options.
Vanguard’s policy research found that “an IRA QDIA could generate more than $100,000 in additional retirement savings across most investor age groups.”
But since there’s currently no QDIA rule for IRAs, you’ll have to invest your funds yourself. Given the potential risk of being out of the market for even a few days, it pays to do this at the time you execute the rollover.
It doesn’t need to be complicated. You might want to consult a financial advisor, but if not, you can research how to set up a simple portfolio suited to your age and risk tolerance. Your IRA provider may provide products to help with this, such as target-date funds, where the asset mix is automatically adjusted over time to reduce risk as you age and move toward the target date (typically retirement).
If you have an IRA that’s uninvested, do yourself the favor of tending to it as soon as possible — it pays to be prepared and act quickly the next time you change jobs.
