So you’ve gone freelance: what to do with your old 401(k) or 403(b) after you’ve made the leap

The paths people take to freelancing bring to mind the old adage about greatness: Some people are born freelancers, some achieve the freelance life, and some have freelancing thrust upon them. A lucky and persistent few can make a living for themselves right from the start of their careers, but for many others the road to freelancing is a long and winding one. Traditional employment weaves in and out of the picture as your life, career, and priorities develop.

There are a lot of pressing questions at hand once you make the leap to freelancing: How much should I charge for my work? What’s the best way to market myself? Where am I getting my health insurance from? One that doesn’t always leap to mind, but can still have an impact on your long-term financial security, involves the retirement savings accounts (like 401(k)s, 403(b)s, and profit sharing plans) you may have had with your old employer(s): what do you do with them once you’ve moved on?

What retirement accounts do I have?

The first step when you’re deciding on what to do with your retirement savings should be to take inventory of all your different accounts. Freelancers are no strangers to jumping from job to job; by the middle of your career you might have picked up a half-dozen different retirement accounts from various ex-employers, dragging them along behind you like the chains of Jacob Marley. What’s more, companies often enroll  employees in their retirement plans automatically in an effort to get them to save more, requiring the employee to opt out if they don’t want to have a retirement contribution deducted from each paycheck. As a result it can be easy to forget that you’ve even been contributing to an account, and even easier to lose track of how many accounts you have and where they’re kept.

The best method I’ve found to keep these accounts organized is to have a spreadsheet – either written down or in an encrypted Excel file – with the following information for each account:

  • Which employer it came from
  • The website where you can access your account information (this is usually an investment company like Fidelity, Vanguard, or T. Rowe Price who is handling the account’s administration and record-keeping)
  • Your user ID and password for the above site

All employer retirement plans are required to send you quarterly account statements. Make sure to enroll in paperless statements if available so you don’t have to worry about those statements being mailed to an old address if you move.

Should I cash out my retirement account?

“Cashing out” a retirement plan involves emptying out the entire account and receiving a check or electronic funds transfer for the proceeds. It can be tempting, especially for someone making the leap to freelancing or starting a business, to get access to that immediate lump sum of money. It’s very important, however, to understand the consequences of cashing out your retirement plan before deciding to do so.

For one thing, you’ll probably owe taxes on the whole amount. Since employer retirement funds, with few exceptions, are pre-tax (meaning you haven’t paid income taxes yet on the contributions you deducted from your paycheck, nor on anything your employer may have contributed), any withdrawals you take are usually treated as taxable income. If you’re under age 59 1/2 when you withdraw the money, the IRS (in all except in some rare cases) tacks on an additional 10% penalty tax as well. That means you’ll only receive about 70% of the account’s total value (minus any additional state and local taxes).

401(k) plans also offer protection from creditors. If you’re in bad financial straits when you cash out the account and are unable to avoid bankruptcy, the end result could be losing your retirement savings. If bankruptcy is a concern, it’s usually best to leave these funds under the protection of the 401(k) plan, where they can’t be touched by creditors.

Lastly, employer retirement plans are designed for one purpose: saving up enough money to live on during retirement. Remember that by withdrawing those funds today you won’t have the ability to use them, or any growth that would have resulted from investing them, in the future.

For the above reasons, very few financial advisors would recommend that someone cash out their retirement accounts. As someone who works with people who do what they love for a living, I know that sometimes, despite all the monetary strings attached, it really can be the right choice for your life, and I don’t begrudge anyone making that decision if they’ve made it thoughtfully. Just be fully aware of the short-term tax and creditor protection consequences of cashing out the account, not to mention the sacrifice of long-term growth of those funds in the years leading up to retirement if you choose to withdraw them now.

What are my other options?

The first option, and often a valid one, is just to leave everything as it is. There’s no theoretical downside to having many different retirement accounts as long as, on an overall level, they are diversified and invested appropriately depending on your age and tolerance for risk. As a practical matter, however, simplicity is often better, and you might prefer to consolidate your retirement savings into a smaller number of accounts. Also, since every plan is a little different in terms of the fees charged, investment options offered, and ease of use, it may also make sense to move your funds out of the worse plans and into the better ones. If this is the case, you have two choices:

Roll over funds from one employer plan to another: Transferring, or “rolling over”, funds from one 401(k) plan to another is common and could be desirable if one plan has significantly lower fees, better investment options, or just a better user experience (website, customer service, etc.) than the others. In contrast with cashing out the account, you won’t get taxed for rolling it over from one plan to another. However, a rollover is only possible if the plan receiving the rollover funds allows it. You can find that out, and how to initiate the rollover, by calling the phone number on your quarterly statement.

Roll over funds into an individual retirement account (IRA): Another type of tax-free transfer involves opening up an IRA at the brokerage firm of your choice and rolling any or all of your employer plan funds into it. Doing this can allow you to invest in a vast variety of stocks, bonds, funds, and other instruments, whereas most employer plans have only a limited menu of investment options. However, the creditor protection of a 401(k) described above is limited in an IRA: your funds are protected up to $1,283,025, a number that is adjusted for inflation every three years (the next adjustment coming in 2019). The taxes and penalties for withdrawing from the account before age 59 1/2 still generally apply to IRAs.

Dealing with former employers’ retirement plans isn’t high on the list of priorities for many people going into freelance work, but small decisions now can have a big impact when it’s time to actually use your retirement savings. It’s important to know the consequences of any decision you make before jumping in. Talk to a financial planner to help you decide on a strategy to meet your goals.