This was originally published at NerdWallet, but was picked up by Nasdaq.com, The San Francisco Gate, The Atlanta Journal Constitution, My San Antonio, The Palm Beach Post, Palm Beach Daily News, Austin American Statesmen among others.
By Marc Smith
When you leave a company where you have a 401(k) retirement plan, you have to decide what to do with the money. You generally have four options:
- Keep the money in the 401(k).
- Roll over your account to your new employer’s 401(k) plan.
- Roll over your account to an IRA.
- Distribute the money to yourself.
The last option involves taxes and penalties, so it’s generally ill-advised. The first option prevents you from making future contributions. For most people, the IRA rollover is the most attractive option.
You should consider all of your options and talk to an advisor about your situation, but for many people, rolling a 401(k) plan into an IRA can be a smart move for two primary reasons: better investment options and lower fees.
If you keep your money in an old employer’s 401(k) plan, you will continue to be limited to the 10 to 15 funds it has selected for you. These funds may not be top-performing funds, and they may have higher-than-average fees. The small number of offerings available to you can limit your ability to invest your account in the way that’s best for your goals and objectives.
From the 401(k) plan’s perspective, it’s cost-effective to limit the number of investment options, but it may not make sense for you personally. If you roll your 401(k) into an IRA, you have a much wider selection of investment options available to you. You can buy mutual funds, exchange-traded funds, bonds or individual stocks. For my clients, I buy individual stocks because they have no fees and you always know exactly what you own and why you own it.
However you choose to invest, you’ll likely have more freedom and more investment options in an IRA than in a 401(k) plan.
In many 401(k) plans, roughly half of the options available are target-date funds, which can come with extra fees. With target-date funds, you estimate when you’d like to retire — say, 2030 — and then pick the corresponding fund, which changes its allocation between stocks and bonds to match your risk tolerance as you get closer to retirement. The downside of target-date funds is that you pay an extra layer of fees. Most target-date funds invest in other mutual funds, which means you end up paying a fee to the target-date fund plus the fees for all the underlying mutual funds. On top of that, you have 401(k) administration fees. All in, you’re paying three layers of fees.
While 401(k) fees have come down recently, they can still add up, and the number of different 401(k) fees often surprises people. It’s not uncommon for investors to pay plan administration fees, investment fees and individual service fees. Even worse, it can be hard to figure out exactly what you’re paying. Plans are required to disclose most fees, but they often bury the disclosure in fine print that most people never read or can barely decipher.
Not all employees are in high-fee 401(k) plans, but if you are and you can roll over your plan to a lower-cost IRA with less expensive investment options, you probably should. If you’re working with an advisor for investment advice, it’s also important to look at the advisor’s fees. Some advisors charge a percentage of assets under their management on top of the fees of underlying funds. Fees shouldn’t be the driving factor in selecting an advisor, but you want to make sure you understand the various fees.
The potential downsides to rolling over your 401(k) won’t apply to most people. The three primary downsides concern:
- People who retire between 55 and 59½: Workers who leave a job after 55 can start taking distributions from their 401(k) penalty-free. But if they rolled over the funds to an IRA, they would have to wait until 59½ to take IRA distributions without penalty.
- People who lose a lawsuit: Most people won’t ever face a lawsuit, but if you’re a high-income earner in a field with legal risk such as medicine or real estate development, you’ll want to consider the legal-protection ramifications of a rollover. Assets in 401(k)s and IRAs generally are protected from bankruptcy. However, not all states offer the same protection to IRAs if the account holder loses a lawsuit and has a judgment against him or her.
- Some high-income earners: For people who can’t contribute to a Roth IRA directly because they exceed the income limits but who use a Roth conversion strategy — converting nondeductible IRA contributions to a Roth IRA — a rollover could cause an unwanted tax liability. That’s because some of the rolled-over funds would end up being counted as additional income. If you plan to use a so-called “backdoor” Roth conversion strategy, make sure you understand the consequences before rolling over your 401(k).
Talk to an advisor before you make a move, to determine whether there are any other potential downsides given your situation.
The most common situation where a rollover is allowed is when you leave a company. Beyond that, if your company is being bought by or merged with another company, you may be given the option to roll over your existing balance. Some plans also allow current employees over 59½ to do rollovers; check with your plan provider for details and make sure you understand any potential risks.
If you decide a rollover is right for you, there are a few important considerations. First, if you have a standard 401(k), you must roll over those pretax funds into a traditional IRA. If you have a Roth 401(k), you would need to roll over the money to a Roth IRA.
You also want to make sure you do a direct rollover from your 401(k) administrator to the financial firm that holds your IRA. This type of transfer is a nontaxable event as long as the money doesn’t go to you. Some firms will mail you a check for a rollover. If this happens, make sure to deposit the check into your IRA within 60 days to avoid having the rollover count as a distribution, which would be taxable.
Talking to an advisor can help you determine whether a rollover is right for you and what type of account to use, and can help ensure that the transfer is completed properly.