Rolling over a 401k

When it comes time to change jobs, it is easy to get caught up in the excitement of the job search and starting a new job. If you have money in your 401k, it is very important that you don’t forget about it and continue to have this money work for you for its intended purpose: your retirement.

It is very tempting when leaving a job to have the amount in the 401k paid out to you to spend now. If you are under 59 ½, than you will be subject to a 10% penalty, as well as having to pay income tax on it. This is worse than never putting money into your 401k at all. If you have $5,000 and take it in cash, you will get $4,500 after the penalty, plus pay income tax (assume 25%), for a net of $3,375. If you left it in your 401k and have 30 years until retirement, it will be worth about $50,000 (assuming 8% annual return). It is certainly worth giving up $3,375 now to have an extra $50,000 at retirement.

One choice you have is to roll your 401k into an IRA. Your plan administrator will be able to give you instructions on how to do this. If you have enough (usually over $5,000) in your 401k, they may allow you to keep it in the 401k, but you will likely have to pay some annual fees. You will likely have many jobs in your lifetime, so I would rather have one large IRA to manage than several smaller 401k accounts held at different institutions. To help centralize your retirement and avoid fees, I am a strong proponent of rolling your 401k into an IRA.

Points on a Mortgage

When you are choosing a home mortgage, you have the option of paying points (one point is equal to one percent of the loan amount) in order to reduce the interest rate, and therefore, reduce the monthly payments. I have found that this is rarely a good idea.

Basically, you are paying now for a return on your investment (points paid) over time. Unfortunately, it is hard to determine how long you will have the loan. Let’s look at an example. Assume you are borrowing $300,000 for 30 years at a fixed rate and you can have an interest rate of 5.625% with no points or 5.375% with one point. The one point will cost you $3,000 (1% of $300,000). Your payments with the no points loan are $1,726.97 per month and the payments with the one point loan are $1,679.92, for a reduction of $47.05 per month.

In order to recoup the $3,000 you paid for your point, you must hold the loan for 63.76 months ($3,000/$47.05). You must also note that this does not take into account the time value of money, as you paid the $3,000 now and received the benefit over time. If you take into account the time value of money and assume you could get a 6% annual return on the $3,000, it will take you about 77 months to recoup the point. Many people look at this and think that because it is a 30-year loan and the point pays itself back after about 5 years, than it is a smart move. However, most people do not hold onto the loan for the full 30 years. If you sell the home or refinance before the 5 years is up, you will have lost some of the money you paid in points. Because the opportunity to refinance may arise if rates drop, you can never be certain you will hold the loan for the 5 years. Additionally, by paying points, you make it less likely that you will be able to refinance and save. In our example, if you chose to not pay points and got the 5.625% loan and rates dropped to 5.375%, you could probably refinance (assuming low closing costs) and save money. If you had paid points, you would stick with your loan and not be able to reduce your payments. I believe that people should save their money and stop paying points.