What Can You Do With an Old 401(k)?

Carrie Schwab Pomerantz
Posted: Feb 27, 2013 12:00 AM

Dear Carrie, My wife has a 401(k) from her last job that she left in 1997. It's just sitting in cash. What can we do with it now? Can we roll it over into a Roth IRA or a ROTH 401(k)? My wife doesn't work anymore. --A Reader

Dear Reader, hile leaving a 401(k) with a former employer often seems like the easiest route, it's not always the best idea in terms of making the most of your retirement savings. That's because some employer-sponsored plans have limited investment choices, limited payout options or substantial fees. With a 401(k) sitting in cash, you have even more reason to move that money to another retirement account -- and get it working for you.

A Roth 401(k) isn't possible because that would only be available through another employer. However, your wife could consider a Roth IRA -- as well as a traditional IRA. The choice mostly comes down to taxes. I'll talk about that first and then get into some other ideas for maximizing your retirement savings.


Decide between a Roth and a traditional IRA

You can roll over a 401(k) directly into either a Roth IRA or a traditional IRA. There are no income limitations on a rollover, so the main consideration is whether you want to pay income taxes on the money now -- or later.

--Roth IRA -- taxes now: Contributions to a 401(k) are made with before-tax dollars, meaning you didn't pay income taxes on the money. The taxes are deferred until you take withdrawals, at which time you pay ordinary income taxes on whatever you withdraw. When you roll over a 401(k) to a Roth IRA, you have to pay those income taxes (SET ITAL) upfront(END ITAL). That's because withdrawals from a Roth are income tax free -- and Uncle Sam is not about to let you get away without paying taxes indefinitely. A rollover to a Roth can mean a big tax bite now.

--Traditional IRA -- taxes later: A traditional IRA works just like your 401(k) -- taxes are deferred until you make a withdrawal. So if you roll over to a traditional IRA, it won't cost you anything now, but you'll pay ordinary income taxes on your money later when you withdraw it.

Either way, you end up paying taxes at some point. The question is, will you be in a higher or lower tax bracket come retirement time? If you think you'll be in the same or a higher tax bracket, rolling over to a Roth could make sense as long as you have the cash available to pay the income taxes now.

However, if you think you'll be in a lower tax bracket when you retire, a traditional IRA would be a better choice. You'll pay nothing now and possibly less in taxes later.

Estate planning is another consideration. When someone inherits a traditional IRA, they're responsible for the income taxes. But with a Roth IRA, your heirs will be able to take the money tax-free. It's something to think about.

Whatever you decide, I suggest that you instruct your broker or bank to complete what is known as a (SET ITAL)direct(END ITAL) rollover. That way you won't have to worry about the paperwork or triggering any taxes.


Now put your money to work

Once you have the money in an IRA, think carefully about how you want to invest. Consider these funds as part of your overall portfolio, not as a separate account. Depending on how the rest of your money is invested, you may not want to keep this much in cash.

While it's a good idea to have some cash in your portfolio, ideally it should be accessible for emergencies or other short-term needs. So an IRA probably isn't the best place for it. From a tax perspective, an IRA is a good place for less tax-efficient investments like individual stocks you want to hold for a year or less, mutual funds that could generate significant short-term capital gains or taxable bond funds.


Consider saving even more -- for both of you

Just because your wife isn't currently working doesn't mean she can't continue to contribute to an IRA. Under current laws, if you're married filing jointly, a working spouse can make IRA contributions on behalf of a nonworking spouse. You can contribute up to the yearly maximum into an IRA for each of you -- even if your wife has no earned income -- as long as your income is equal to both contributions. The maximum contribution for 2013 is $5,500 with a catch up contribution of $1,000 more if you're 50 or older.

My advice is to roll over that 401(k) as soon as possible. With the potential for growth and the opportunities to save more, you'll be glad you did.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.