11 Aug Should I Rollover My 401(k) to an IRA?

When an investor separates from employment, he or she typically gains more flexibility over their assets held in the former employer’s company-sponsored retirement plan. For instance, the investor can withdraw the funds (cash out) or, if allowed, keep those assets in the plan. Alternatively, investors can choose to move the assets into an IRA. The best option is determined by the unique circumstances of the investor – but withdrawing the assets isn’t typically desirable because of the tax and potential penalties involved. Most investors weigh the pros and cons of keeping the assets put or rolling them into an IRA. The decision to rollover retirement assets from a 401(k) to an IRA can be complex, and the decision is generally irrevocable. Some key factors to consider are fees, investment options, withdrawal options, tax implications, beneficiary designations, and creditor protections.

Fees:

401(k)-plan costs can vary significantly – but most plans benefit from economies of scale. As the total plan assets increase, the total plan costs tend to decrease. Smaller plans can have fees around 2.5% of plan assets, while larger plans may have fees around .4% of plan assets or even lower. While some employers will pay a portion of plan fees, which include administration, record-keeping, and investment expenses, not all do. It’s important to understand the fees actually paid by the participant and compare those fees to the fees associated with an IRA. Are the fees reasonable?

Investment Options:

Both 401(k)s and IRAs are investment vehicles which provide the investor access to investments. Defined-contribution plans such as 401(k)s tend to limit investment options through an available menu. This isn’t inherently bad – an investor can usually build a well-diversified portfolio that meets his or her objectives with available options. However, there may be asset classes or investments that are not offered through the 401(k). An investor might find that an IRA will better serve his or her goals.

Withdrawal Options:

An employer’s retirement plan may limit the number of annual withdrawals or only allow for monthly or quarterly withdrawals, whereas an IRA will be more accommodating. It’s important to read and understand the 401(k)-plan document to understand all its nuances.

Tax Considerations:

Separation from Service After Age 55: Plan participants who separate from service during or after the year they reach age 55 may not be subject to the penalty tax on early distributions. Rolling over the 401(k) into an IRA will subject any distributions made before age 59 ½ to the penalty tax. However, not all qualified retirement plans like 401(k)s allow distributions before normal retirement age. Again, read and understand the plan document.

Penalty-free distributions from IRA: First-time home-buyers can take a distribution up to a lifetime maximum of $10,000 penalty-free from an IRA. Also, distributions for higher education expenses and medical insurance for the unemployed can also potentially be penalty-free. In these cases, it may make sense to do partial rollovers from the 401(k) to an IRA to take advantage of the penalty-free treatment. For more information on how to avoid the penalty tax on early distributions from retirement accounts, see here.

Net Unrealized Appreciation: If the 401(k)-plan includes employer stock, consideration should be given to whether, and to what extent, the plan participant would benefit from the favorable long-term capital gains treatment under the “Net Unrealized Appreciation” rules of IRC 402(e)(4). For more information, see this blog post by Michael Kitces.

Beneficiary Designations:

Generally, an IRA will allow for greater customization in beneficiary listings.

Creditor Protections:

Amounts rolled over into an IRA will have the same bankruptcy protections as those that stayed put in a defined-contribution plan – although rollover IRAs should be segregated from contributory IRA accounts because there is a cap on the protected amount for contributory IRAs. In non-bankruptcy proceedings, creditor protections will vary by state, so consideration should be given to the investor’s state of residence or desired future state of residence when considering a rollover.

Additionally, the financial strength of the company sponsoring the 401(k)-plan should be evaluated. If the company files for bankruptcy, the 401(k)-plan assets could be tied up for a significant amount of time.

Conclusion:

The Department of Labor has noted that “rollovers from an ERISA plan to an IRA can involve the entirety of workers’ savings over a lifetime of work.” Therefore, the IRA rollover decision should not be taken lightly. Every situation, as every individual investor, is unique. If you are unsure about the consequences of the IRA rollover decision or want more information, contact a qualified CPA financial planner.

Originally posted 8/11/2017