The 401(k) Rollover Mistake Costing Amercans Billions Each Year (Vanguard)

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When rolling over your 401k to an IRA, there’s one simple mistake that many Americans make. This error could cost you hundreds of thousands of dollars. According to a recent Wall Street Journal article, Vanguard estimates this mistake is costing Americans a staggering $172 billion in lost market gains each year.
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In this post, I’ll break down the mistake and, most importantly, how to avoid it. As always, here the YouTube video if you prefer to watch instead of read: 

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What is a 401(k) Rollover?
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Before diving into the mistake, let’s quickly review what a 401k rollover is. A 401k rollover refers to moving your retirement savings from a previous employer’s 401k plan into another qualified retirement account, such as an IRA (Individual Retirement Account), a 403(b), or even another 401k.
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Rollovers are most common after leaving a job, but in certain cases, you can roll over money from a current employer’s plan if you’re over age 59 ½.
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Direct vs. Indirect Rollovers
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There are two main types of rollovers:
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1. Direct Rollovers: This is the preferred method. In a direct rollover, your 401k provider sends the funds directly to your new retirement account, such as an IRA. If you have a 401k with Vanguard and you’re rolling over to an IRA with Fidelity, for example, Vanguard would issue a check payable to Fidelity for the benefit of your IRA.
2. Indirect Rollovers: With an indirect rollover, the money is sent to you first, and you then have 60 days to deposit it into your new IRA. However, this method is risky because taxes must be withheld, and you only get 80% of your balance upfront, which you’ll need to replace when depositing into the IRA to avoid a tax penalty.
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For most people, direct rollovers are the safest option.
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The Costly Mistake to Avoid: Not Reinvesting Rollover Funds
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The most expensive mistake people make when rolling over their 401k to an IRA is failing to reinvest the rollover funds once they arrive in the IRA.
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When you roll over a 401k, the rollover process typically involves a physical check, an outdated but common method in the industry. Before the check is sent, your investments in the 401k are liquidated, turning them into cash.
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Here’s where the problem arises: once that check is deposited into your IRA, the cash sits there uninvested unless you manually reinvest it.
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The Numbers Behind the Mistake
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Let’s consider an example from Vanguard research in 2015, which revealed that a third of people who rolled over their 401k into an IRA in that year still had the funds sitting in cash years later.
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According to the Rule of 72, if your investments return 10% annually, your money would double in roughly seven years. By failing to reinvest the rollover cash, people miss out on this compound growth.
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Vanguard estimates that Americans collectively lose $172 billion annually due to this mistake.
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Real-Life Example
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In one instance, an advisor worked with a couple who had rolled over $400,000 from their 401k into an IRA a year earlier. The couple was puzzled that their money hadn’t grown despite the stock market gaining over 20% that year.
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The advisor quickly discovered the issue: their funds were still sitting in cash! As a result, they missed out on about $100,000 in potential gains for that year alone.
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Since 1926, U.S. large-cap stocks have returned around 7.19% per year on average (adjusted for inflation), while cash typically returns closer to 3% after inflation. This difference can have an enormous impact over time.
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The Compounding Effect of This Mistake
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Let’s examine the compounding effect of leaving funds uninvested over the long term. If that same couple had properly reinvested their $400,000 rollover, their advisor estimated that after 20 years, they could have had $420,000 more.
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This simple oversight of failing to reinvest can cost you substantial amounts of money, especially when it compounds over years or even decades.
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How to Avoid This Costly Mistake
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Here are three ways to avoid missing out on potential gains:
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1. Leave Your Money in the 401k Plan
   You’re not required to roll over your 401k immediately after leaving a job. In many cases, you can leave your money in your previous employer’s plan, and it will stay invested as it was when you were employed. However, you won’t be able to add more money to the account.
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2. Reinvest Immediately After the Rollover
   When you initiate a rollover, think of it as a three-step process:
   • Open an IRA (if you don’t already have one).
   • Initiate the rollover with your old 401k provider (opt for a direct rollover).
   • Monitor the deposit and make sure you immediately reinvest the funds once they hit your IRA.

Remember, the IRA custodian doesn’t automatically reinvest your funds for you—you must manually choose your investments.
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1. Work with a Financial Advisor
   Having a financial advisor can help you avoid costly mistakes like this one. An advisor can guide you through the rollover process and ensure that your funds are promptly reinvested. If you prefer a more automated solution, consider using a robo-advisor. These online platforms can automatically invest any cash that hits your account.
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Pros and Cons of Rolling Over to an IRA
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While the primary focus here is avoiding the reinvestment mistake, it’s important to understand the general advantages and disadvantages of rolling over your 401k into an IRA.
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Pros:

• More Investment Options: 401(k) plans often limit investment choices, whereas an IRA offers more flexibility in choosing stocks, bonds, ETFs, etc.
• Consolidation: Rolling over multiple 401k accounts into a single IRA can make it easier to manage your retirement funds.
• Potential Lower Fees: Depending on the fees associated with your 401k plan, an IRA could offer lower administrative costs.

Cons:

• Loss of Some 401k Protections: 401ks often have specific creditor protections, which might not apply to IRAs.
• No Employer Match: You’ll no longer receive an employer match, which some 401ks offer.
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Stay on Top of Your Rollover Process
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Rolling over your 401k into an IRA can be a smart financial move, but you must stay diligent throughout the process.
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If you’re a DIY investor, remember these key takeaways:
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• Avoid indirect rollovers and the potential tax pitfalls they bring.
• When rolling over into an IRA, monitor the deposit and reinvest as soon as possible.
• Consider working with an advisor if you want guidance through the process.
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Rolling over to a new 401k? The good news is that your money is usually automatically invested. In contrast, IRA accounts require you to manually reinvest. Stay proactive and avoid the costly mistake of leaving your funds sitting in cash.
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If you’re nearing retirement or unsure about your 401k rollover options, check out our comprehensive guide on the various options and their pros and cons. Make sure to reinvest, and don’t leave money on the table!
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Need help managing your rollover? Reach out to Spark Wealth Advisors for personalized guidance.

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