I’m answering another reader on Debt BLAG today. Let’s look at a question from Eithne (Pronounced enya, not her real name):
I’m in my mid-20s and recently started freelancing after having a 401(k) at a company I left around January. I want to set up something to roll that money over into a new account. (1)
A financial adviser referred by family says I should open an individual 401(k) because the limit (2) is higher than a Roth IRA which has a limit of $5000, right? He also said I can take a loan from the fund at any time.
Signing up for a 401(k) with him would cost $40 per year for his company plus 1% for him. Should I look somewhere else? (3)
How should I decide where to invest my money each year? Does it depend on risk? I don’t even know what questions to ask. (4) -Eithne [with emphasis and numbering added by me]
First off, congratulations on making the move. It’s certainly takes a certain kind of courage to jump into that world.
Let’s go through your questions individually.
1) Rolling over an old 401(K) into a One-Participant 401(k) Plan or a SEP IRA
You mention two, but you’ve actually got four options here:
- Cash out with big penalties. You’ll have to pay taxes and a 10% penalty for not being of retirement age . Don’t do this.
- Keep it with your old employer. If there’s something you like about your old employer’s plan — maybe it has low fees or good investment options — then this could make sense. Just be mindful of required minimums to keep it open, which is important because you won’t be able to make new contributions.
- Roll over into an IRA. By rolling over into an IRA, you’d be able to make new contributions, which it sounds like you’re looking to do. As you know, you won’t be able to take loans against your balance, but you can take distributions that could be subject to taxes and a penalty. You mention a Roth IRA in your note, but because you’re acting as both employee and employer, a SEP IRA is what you would go for. (Source: IRS, Choosing a retirement plan: SEP)
- Roll over into a One-Participant 401(k). You may also see this called a Solo 401(k) or an Individual 401(k). You can also make new contributions to a One-Participant 401(k). Some, but not all, One-Participant 401(k) trustees allow loans; it sounds like the one you’re talking to does. (Source: IRS, One-Participant 401(k) Plans)
I’d recommend one of the last two.
2) Contribution limits
Both the SEP IRA and the One-Participant 401(k) have a hard upper limit of $52,000 for the 2014 tax year, and it’ll be adjusted in the future based on a measure of inflation. How each option gets to that $52,000 limit is a bit interesting — again because you’re both employee and employer:
- The SEP IRA lets you contribute 25% of your income.
- The One-Participant 401(k) lets you contribute up to the employee cap of $17,500 plus up to 25% of income (As long as you don’t try to contribute more than 100% of your income).
The One-Participant 401(k) has higher limits, so because of the increased flexibility, I agree with your adviser’s recommendation to follow that route.
3) Exploring other options
It’s tough for me to say whether you should be talking to other people. Maybe try to think of it this way:
Suppose you’re starting with $4,000 in your 401(k), each year, before even dealing with market risk and inflation, you’ll lose 1% to his company (the $40 fee / your $4,000 balance) and 1% to him.
That’s not a insignificant hole starting out at all — especially in a world with plenty of discount brokerages and low-cost managers out there. Think long and hard when you’re balancing the value you’ll get from him against these costs.
4) Factors to consider when determining an investment approach
Unfortunately, I can’t get too specific here. I will say that your investment approach should depend on a lot of things including:
- Your time horizon. The greater the gap between your age now and the age you plan to retire, the greater chance that your portfolio can overcome the occasional bump in the road.
- Your tolerance for risk. In some cases, rewards increase relative to risks taken, but if the uncertainty of your portfolio makes you sick, then what’s the point?
- Your anticipated income streams. I bring this up because you mentioned taking loans from your portfolio. Obviously, it would be better for the final value of your nest egg if you didn’t do this, but I can see how it might be inevitable given the feast-or-famine nature of finding freelance work. Make sure to mention this too.
- The rest of your financial picture. If you’ve got a big emergency fund, no debt, other assets, and low expenses, then it decreases the chances that you’ll have to dip into your retirement savings early.
I could send you a ton more resources if you’re interested in portfolio theory.
That said, those last couple points might actually be the most important; you can’t control how the market affects the money in your retirement account, but you can control how much you put in by minimizing expenses and saving as much as possible.
I hope this all helps!
Did I leave anything out or get anything wrong? Who else has tips for Eithne?