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Many investors unknowingly make a costly mistake when transferring their money from a 401(k) plan to an individual retirement account: leaving their money in cash.
Switching from a workplace retirement plan to an IRA is common after reaching certain milestones, such as changing jobs or retiring. About 5.7 million people rolled A total of $618 billion will go into IRAs in 2020, according to the most recent IRS data.
However, many investors who move their money into an IRA park it in cash for months or years instead of investing it — a move that causes their savings to “wither away,” according to a recent Vanguard researcher. analysis.
About two-thirds of rollover investors unintentionally hold cash: 68% don’t realize how their assets are invested, compared to 35% who prefer a cash investment, according to Vanguard.
The asset manager surveyed 556 investors who completed a rollover to a Vanguard IRA in 2023 and kept those assets in a money market fund until June 2024. (Respondents could report more than one reason for keeping their rollover in cash.)
“IRA money is a billion-dollar blind spot,” Andy Reed, head of investor behavior research at Vanguard, said in the analysis.
‘It will always be cash’
The pension system itself likely contributes to this blind spot, pension experts say.
Let’s say a 401(k) investor keeps his money in an S&P 500 stock index fund. The investor would technically liquidate that position when he rolled his money into an IRA. The financial institution receiving the money does not automatically invest the savings in an S&P 500 fund; the account owner must make an active decision to withdraw the money from cash.
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“That’s one of the challenges: It always turns into cash,” says Philip Chao, a certified financial planner and founder of Experiential Wealth based in Cabin John, Maryland. “It’s sitting there in cash until you do something.”
According to Vanguard’s research, about 48% of people believed (wrongly) that their rollover was automatically invested.
When holding cash can be a ‘mistake’
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Holding cash — perhaps in a high-yield savings account, a certificate of deposit or a money market fund — generally makes sense for people building an emergency fund or for people saving for short-term needs such as a down payment on a house.
But saving bundles of money for the long term can be problematic, according to financial advisors.
Investors may feel like they’re protecting their retirement savings from the vagaries of the stock and bond markets by saving cash, but they’re likely doing themselves a disservice, advisors warn.
The interest on cash may be too meager to keep up with inflation for many years and would likely not be enough to generate sufficient savings for retirement.
“99% of the time, putting meaningful long-term money into cash is a mistake unless you’re ready to retire,” Chao said. “History has shown that.”
“If you invest twenty, thirty, forty years, [cash] makes no sense because the returns are far too small,” Chao said.
Using cash as a “temporary parking spot” in the short term — perhaps for a month or so while you make an investment decision — is OK, Chao explains.
“The problem is that most people eventually forget about it and it sits there in cash for years, decades, which is absolutely insane,” he said.
The relatively high cash returns over the past two years on some types of cash accounts – perhaps around 5% or more – may have given investors a false sense of security.
However, investors are unlikely to maintain these returns for long, Tony Miano, investment strategy analyst at the Wells Fargo Investment Institute, wrote on Monday.
That’s because the US Federal Reserve is expected to initiate a round of interest rate cuts this week. Investors should “reposition excess cash,” Miano said.
Investors should also ask themselves whether it’s necessary to roll money from their 401(k) plan into an IRA, as there are many pros and cons, Chao said.