Vanguard Says People Under 55 Are Making This $130K Mistake When Rolling Money Over From Their 401(k) To IRA

Retirement vehicles like 401(k) and individual retirement accounts (IRA) offer multiple tax benefits, high annual contribution limits, and investment options tailored to grow your hard-earned money with the power of compounding interest. Many 401(k) account holders choose to roll over their 401(k) investments into a traditional IRA for more personalised investment choices, better control over capital allocation, lower fees, and the option to explore Roth IRAs that wealthy people use to get around income and contribution limits and avoid taxes on withdrawals. However, most are unaware that money rolled over to an IRA account sits as cash and is not automatically reinvested. Investment management firm Vanguard estimated that investors under 55 making this mistake are losing north of $130,000 by 65 because they didn't reinvest the rolled-over money into target-date funds.

Vanguard found that almost 30% of its clients who had rolled over money into IRAs last year were yet to reinvest the idle cash as of mid-2024. Upon inquiring over 500 clients about why they left the funds in cash, most were surprised to find out their money wasn't automatically invested in stock and bonds after the rollover. The investment management fund's head of investor behaviour research, Andy Reed, noted in a September 5 report that "IRA cash is a billion-dollar blind spot."

Lack of Knowledge About IRA Rollovers

Around 70% of the clients whose funds remained uninvested in IRAs were seasoned investors, aware of the market risks of mutual funds and money market funds. According to Vanguard investment strategy analyst Ariana Abousaeedi, the primary challenge is that most investors lack knowledge of IRA rollovers. The expert shared that investors accustomed to having their 401(k) contributions automatically invested in instruments like target-date funds are likelier to believe IRAs work the same way. However, money in IRAs requires active participant engagement to get invested.

"Many investors who have dutifully saved for their retirement in the workplace are unaware that their rollover assets are sitting in cash," the Vanguard report noted. "Take a close look at your portfolio to ensure it's allocated in a way that makes sense for your long-term plans. What you find may come as a surprise."

Although high short-term interest rates on cash deposits have offered decent returns in recent times, the yields on cash could decline as the US Federal Reserve prepares for rate cuts after years of monetary tightening to curb sticky inflation. While Vanguard is pushing for provisions that enable automatic investments when you roll over cash into an IRA, the economic landscape makes it a good time to ensure rolled-over funds are appropriately invested in your IRA account.

What Is A Roth IRA, And Should You Have One?

Traditional IRAs compound your pre-tax money without subjecting capital gains to taxes and even allow you to deduct IRA contributions from your annual taxable income. While withdrawals are penalty-free after 59½, they are taxed as regular income. Meanwhile, Roth IRAs grow your post-tax contributions where withdrawals in retirement are tax-free, and you are not obliged to make required minimum distributions after a certain age.

However, you can open a Roth IRA if your modified adjusted gross income is below $161,000 for the current financial year or a maximum of $240,000 for those filing jointly. These income thresholds prevent high-income individuals from opening a Roth IRA account. However, many convert their traditional IRA to a Roth IRA to bypass the income limits. In the process, you pay taxes on your pre-tax, traditional IRA contributions and capital gains only once and never again on your Roth IRA funds or withdrawals. Wealthy individuals often use this strategy during tax planning because there's no income limit for opening a traditional IRA or conditions on who can convert IRAs.

Disclaimer: Our digital media content is for informational purposes only and not investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks and past performance doesn't indicate future returns.