When I left my last place of employment, I rolled all of my 401(k) funds into a traditional IRA. I figured doing so was a no-brainer, but I recently read an article in Kiplinger’s Retirement Report that, while validating my decision, also gives some reasons why a rollover is not always the best course of action.
It seems that brokerages and employers are increasingly competing for those retirement funds. According to the Investment Company Institute, more than 50 million employees and retirees hold $3 trillion in 401(k) plans, which means that brokerage firms and mutual fund companies are clamoring for the business. TD Ameritrade and E*Trade are offering up to $500 to buy rollover business.
At the same time, employers who have been historically non-committal about keeping retirees in their plans have begun offering low-cost index and exchange-traded funds, target-date retirement funds and annuities as a carrot to hang on to 401(k) participants.
So…should you roll your 401(k) to an IRA or not?
Advantages of rolling a 401(k) to an IRA
More investment choices
The very best 401(k) plans have limited investment options whereas an IRA gives you access to nearly unlimited investment options.
Flexibility
With an IRA, you can withdraw money whenever you need it, but not necessarily with a typical 401(k). Some limit the frequency of withdrawals; others set all or nothing restrictions.
Simplicity
Many workers leave a string of 401(k) investments behind as they switch jobs over their career. Rolling all into a single IRA greatly simplifies the retirement savings; making it easier to monitor investments, plan allocations and rebalance.
Easier to handle required minimum distributions (RMDs) at age 70 ½
With traditional IRAs (there is no RMD for Roth IRAs), the RMD is based on the total amount in all your IRAs with the RMD distribution coming from any account or combination of accounts. With 401(k)s at age 70 ½, you must calculate each RMD separately and take the money from that account.
Some estate planning advantages
Heirs can normally take tax-deferred distributions from an IRA over their lifetimes; most 401(k) plans force heirs to take assets after the account holder dies. Note that the beneficiary has the option of rolling the 401(k) into an IRA, but this is a tricky process and is better done by the account holder while living.
Reasons for sticking with your 401(k)
Relaxed penalty rules for early distribution
If you retire or get laid off between ages 55 and 59 ½, you are able to take penalty free distributions from a 401(k) while you would be penalized 10% for withdrawing funds from an IRA.
Protection from creditors
The 401(k) funds can’t be touched by creditors in a bankruptcy or by plaintiffs in a civil lawsuit. IRA funds, however, have limited protection and differ from state to state.
Delayed RMD for workers over 70½
As long as you are still working at age 70½ , no required minimum distribution is taken from your 401(k). With an IRA, the RMD is a must whether you continue to work or not.
Possibility of rolling an inherited plan to a Roth IRA
New rules allow nonspouse beneficiaries to roll a 401(k) to a Roth IRA, something that cannot be done with an inherited traditional IRA.
Comfort
Some retirees are used to their 401(k) plans and are not comfortable with starting out fresh with the management of an IRA.
How about the costs?
Deciphering the management expense of your 401(k) or IRA can be a challenge. With your 401(k), you will need to find the expense ratio of each fund. How do you do this? Try the fund’s Web site or the plan’s Web site. According to Kiplinger’s Retirement Report, an expense ratio of 1% or less is reasonable. You shouldn’t have trouble finding funds in your IRA with comparable expense ratios. A new tool, by BrightScope, a San Diego firm, has tabulated the administration costs, investment fees, returns and quality of investments for 45,000 companies. Visit www.brightscope.com, enter the company name, and you will get a score of between 1 (worst) and 100 (best). Give this tool a try…it is really that simple.
Conclusion
Because of more choices, flexibility and simplicity of the IRA, most 401(k) holders should seriously consider rolling to the IRA. However, this decision is not a no-brainer. Think it through and understand what you are doing before deciding.
When leaving employment with a 401(k) provider, have you rolled your 401(k) to an IRA, rolled it to your new company’s plan, left it in your previous company’s plan, or cashed it out? Why did you make the decision you made? What recommendations would you give to others who are leaving a 401(k) employer?
photo credit: pfala
Evan says
Goes to show you that there is no one size fits all! Was this job change recent?
joeplemon says
Evan,
About a year ago. Spending most of my career in government work, this was the only 401(k) job I ever had.
Jason @ Redeeming Riches says
Joe, looks like we had similar ideas today! Great minds think alike! =)
joeplemon says
Jason,
Very funny! I like to say “Great minds think alike…and so do ours.”
Craig/FFB says
These days you really have to look at the 401(k) plan and see what benefits it has. My previous employer had their 401(k) with a major brokerage company and they were a huge company too so they were able to get very low expense funds in their plan.
Also, with some 401(k)’s you get more diversity in fund companies and less expensive trading between funds.
Still, I rolled my 401(k) over and I prefer having control over my funds.
joeplemon says
Craig,
Thanks for sharing why you rolled your 401(k) to an IRA.
I greatly appreciated your excellent post along the same lines as this one. Readers: if you want to know more pros and cons of moving your 401(k), jump over to Free From Broke to read http://freefrombroke.com/2010/06/choices-401k-leave-your-job.html.
Darren says
I’ve rolled over twice, both times into the same IRA. I just wanted them in the same account, and the lower fees were a nice benefit too.
Cashing out is almost never a good idea. I know one person who did it, and though I don’t know if it was for an emergency or not, I don’t think it was. I just cringed.
joeplemon says
Darren,
Seems like rolling over to an IRA is the popular answer. Thanks for sharing and telling why.
I agree that cashing out is almost never a good idea. Something like avoiding a foreclosure might make it justifiable, but I would have to do a lot of thinking even then.
Mike says
Another big difference for me is the amount you can contribute in a calendar year. The limit for a 401k is $16,500 while the IRA is a paltry $5,000! That’s potentially a very BIG difference.
joeplemon says
Mike,
Yes, the contribution caps are different for 401k and IRA, but I am not getting how that difference plays into whether you should roll a 401k into an IRA when you leave an employer. Can you help me out?
Mike says
Well, I guess it all depends on what you plan on doing with the rollover… if you’re just moving it to an IRA and you’re not planning on making more contributions, then it doesn’t matter at all.
However, if you’re looking at a 401k plan with lousy options or going with an IRA where you have a world of options, then contribution caps become important. That’s assuming you want to concentrate all of your retirement savings in one account to maximize effectiveness and minimize the overhead – more accounts means more funds and more homework.
I’m looking at just such a situation. I recently changed jobs and my new employer’s 401k plan stinks – no employer match to boot! But the $5,000 cap on an IRA is less than 10% of my salary and I’m not comfortable with putting so little away each year. But I’m not crazy about putting more money in the crumby 401k funds either…