Avoid the 401(k) to IRA Rollover Cash Trap

November

Avoid the 401(k) to IRA Rollover Cash Trap

November 4, 2024

Many Americans are potentially missing out on retirement savings by falling victims to the 401(k) to IRA rollover cash trap.

According to Andy Reed, head of investor behavior research at Vanguard, “IRA cash is a billion-dollar blind spot.”¹

A recent report from Vanguard found that almost two-thirds of rollover investors unintentionally hold cash without investing it.²

Keep reading to see if you may be one of the 401(k) to IRA rollover cash trap victims.

Explaining the 401(k) to IRA Rollover Cash Trap

401(k) to IRA Rollover

401(k) rollovers shouldn’t be complicated, but they are.

We’ve written about costly 401(k) rollover mistakes and how to avoid them.

However, another kind of rollover issue affects many Americans without them even knowing it.

This is the 401(k) to IRA rollover cash trap.

When investors roll over their 401(k) to an IRA, either because they are changing jobs or retiring, they may unintentionally allow the rollover assets to park as cash for months and sometimes years.

This is called “holding cash” or “parking cash.”

The problem is that investors aren’t holding cash on purpose – they simply do not know that rollovers are held in cash as a default.

Andy Reed, head of investor behavior research at Vanguard, explains, “Many IRA holders want to invest their retirement savings in the stock market and think that they’re invested following a rollover. In reality, they’re sitting in money market funds.”³

Vanguard found, “Close to 50% of those investors mistakenly believed that IRA contributions were automatically invested and 46% did not realize their contributions were allocated to money market funds by default.”⁴

This is especially true for those enrolled in target-date funds who mistakenly assumed that once they rolled over their 401(k) to an IRA, it would work the same way.

The critical difference is that the investor must decide to move the cash and invest.

But most don’t understand this to be true.

Vanguard found that 68% don’t realize how their assets are invested and are not intentionally holding cash.⁵

For example, “About 48% of people (incorrectly) believed their rollover was automatically invested.”⁶

You must take steps to ensure your cash doesn’t stay parked and, instead, is giving opportunities to move and grow.

Why Holding Cash May Not Be the Right Choice for Investors

401(k) to IRA Rollover

There is a right time for holding cash – but retirement isn’t it.

Generally, holding cash is a good idea when you are saving money for something in the immediate future, such as a down payment on a home. Or to have in your emergency fund.

But, if you have a substantial amount of cash you want to use in retirement, it should be invested.

The interest accrued on cash savings will be much more limited than if it were invested.

Global Asset Management produced a hidden cash cost analysis over a 20-year period.

According to their data, to reach a $500,000 savings goal:

If you invest in a balanced portfolio, you would need to contribute $305,000 over 20 years ($15,250 per year).
If you keep your money in cash, you would need to save $431,000 over 20 years ($21,550 per year).
The hidden cost of cash is $126,000 ($6,300 per year). This is because your cash investments don’t offer nearly as much growth potential as the balanced portfolio. So if you want to save $500,000 over the same time period, you would have to make larger contributions.⁷

The return on cash is simply too small when you are looking at long-term finances.

It’s An Easy Mistake to Make

401(k) to IRA Rollover

The 401(k) to IRA rollover cash trap is an easy mistake to make.

According to Vanguard, “It tends to be an error of omission rather than commission: They are twice as likely to hold cash unintentionally as they are to do so deliberately.”⁸

Investors simply forget and do not move the money from its parking spot to the right investment allocation.

Even those who have dutifully saved for retirement may not even be aware that they have rollover assets holding in cash.

On the other hand, some investors are simply overwhelmed by the number of IRA investment options.

Vanguard explains, “While 401(k) plans typically offer a limited menu of funds handpicked by plan sponsors, IRAs offer thousands of choices among funds, individual stocks, bonds, certificates of deposit, and other asset classes. That plethora of choices can be unwelcome: One in four rollover cash investors reported feeling overwhelmed by the number of options.”⁹

This results in choice overload and decision paralysis.

How to Avoid the 401(k) to IRA Rollover Cash Trap

401(k) to IRA Rollover

Staying in cash can result in missed opportunities to earn investment returns, potentially leading to retirement shortfalls.

To avoid this mistake, investors should closely examine their portfolios after a rollover to ensure they are allocated appropriately for their long-term plans.

It is critical to stay engaged with your retirement accounts.

Be an active investor.

Regularly review and adjust IRA allocations based on your retirement goals and risk tolerance to ensure long-term success.

Seek Help Before You Make a Rollover Mistake

401(k) to IRA Rollover

Understanding all rollovers before you make a move is important, and seeking professional help is just as important.

Speak with a financial advisor to learn about the differences between 401(k) plans and IRAs, particularly regarding automatic investments.

Ask for guidance when it comes to making decisions about what to do with the cash from a 401(k) to an IRA rollover.

Each investor’s situation is unique, and speaking with someone may help you avoid costly 401(k) rollover mistakes and make the best decision possible for your financial future.

Have questions about rolling over your 401(k)? Book a complimentary 15-minute 401(k) Strategy Session with one of our advisors.

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