When an employee changes or loses a job or retires, he/she can opt to roll the money in his former employer’s 401(k) into an IRA or into a new employer’s 401(k) plan…but he also usually has the option of letting the money remain in the former employer’s 401(k).
Why would someone leave their retirement money with a former employer? And when is an IRA rollover the better bet? Retirement-planning expert Robert Carlson recently explained to Bottom Line Personal that this decision depends on a range of factors.
Rolling the money into an IRA often is preferable if…
The 401(k) has high costs
Does the 401(k) impose an annual account fee? Some employers absorb the costs of offering a 401(k) plan, but others pass these costs along to employees in the form of a fee. If your former employer does the latter, switching to an IRA could be a money saver. Also compare the expense ratios of the mutual funds (or other investments) available through the 401(k) to those of the mutual funds you would select if you moved the money to an IRA at the investment company of your choice. Tip: If the 401(k) features “institutional” shares of mutual funds, that could be a clue that it offers low-cost investments. Institutional shares tend to have relatively low expense ratios, though there are exceptions.
The 401(k) features underperforming mutual funds
If the funds (or other investments) available through the 401(k) have unimpressive track records, you’re almost certainly better off rolling your money into an IRA or, potentially, into your new employer’s 401(k).
Keeping your retirement savings as simple as possible is a top priority
If you’ve changed employers multiple times over the years, you might have numerous 401(k)s. If that’s making it challenging to keep track of your retirement savings and/or maintain your desired balance among different asset classes, rolling all of those 401(k)s into one IRA could keep things as consolidated and uncomplicated as possible.
The 401(k) plan creates hurdles for beneficiaries
Some 401(k) plans require people who inherit accounts to remove all assets within a certain number of years. If that’s the case with your former employer’s 401(k), rolling the money into an IRA could spare your heirs from having to deal with a money-management hassle.
The 401(k) balance is very low
If your 401(k) account balance is below $7,000 when you leave your employer, that employer has the right to remove the money from its plan with or without your consent. Typically, the employer will roll the money into an IRA in the former employee’s name. But if your balance is below $1,000, your former employer could simply cash out your 401(k) and send you a check, potentially triggering taxes and a penalty which may be deducted automatically.
Keeping the money in the former employer’s 401(k) is often preferable if…
The 401(k) features low-cost institutional shares of desirable mutual funds
The institutional shares available through the 401(k) might have lower expense ratios than the funds you could obtain through an IRA.
The 401(k) features an annuity option that you might wish to select in the future
The 2020s have seen an increase in the number of 401(k) plans offering attractive annuity options. In fact, many large-employer 401(k) plans have begun using their considerable market power to negotiate better annuity terms with insurance companies than are available on the open market. If the idea of shifting some portion of your retirement savings to an annuity is appealing, keeping money in a large company’s 401(k) might be worthwhile to maintain your access to its annuity offerings.
You might want to access your money before age 59½
If you withdraw money from a tax-deferred IRA or 401(k) before age 59½, there’s a good chance you’ll have to pay a 10% early-distribution penalty. But something called “the rule of 55” provides a bit more flexibility with 401(k)s—if you leave or lose a job during or later than the calendar year in which you turn 55, you can make withdrawals from that employer’s 401(k) as early as age 55 without incurring this penalty. This penalty-free early-withdrawal opportunity is lost if you roll the 401(k) into an IRA.
Protection from lawsuits and creditors is a priority, and your state’s IRA protection laws are weak
The Employee Retirement Income Security Act (ERISA) provides 401(k) accounts with strong protection from most creditors and lawsuit judgements. IRAs receive significantly less protection under Federal law. IRAs do receive additional protections under state law, but the strength of those state laws vary greatly. If you have reason to worry about being sued or pursued by creditors, discuss the strength of your state’s laws with an attorney before rolling 401(k) assets into an IRA.
Seven 401(k) Rollover Mistakes
If you decide that rolling over your 401(k) into an IRA is right for you, be wary of these potentially costly errors…
- Rolling after-tax 401(k) assets into a traditional IRA. Particular care must be taken with rollovers when there’s any after-tax money in the 401(k). One option: Roll your pretax 401(k) money into a traditional IRA and your after-tax 401(k) money into a Roth IRA.
- Failing to repay a 401(k) loan. If you borrowed money from your 401(k), you’ll probably need to pay it back before rolling your savings into an IRA. Failure to do so could lead to the outstanding loan balance being considered a distribution from your 401(k), triggering taxes and potentially a 10% early-withdrawal penalty. In fact, many 401(k)s also require employees to pay back loans relatively promptly when they leave the employer even if they don’t roll their money into an IRA. Make sure you know 401(k) loan-repayment rules and deadlines whether or not you’re planning to do a rollover.
- Taking possession of 401(k) money. Ask your former employer’s 401(k) plan provider to send your savings directly to the IRA provider that you’ve selected, not to you. It’s not necessarily a disaster if the money is sent to you instead—you would have 60 days to complete the rollover by forwarding it to the IRA provider—but that could add unnecessary complexity to the process. Example: If the 401(k) provider sends the money to you, it might withhold a chunk of it and send a portion of your retirement savings to the IRS to cover the potential tax bill that would be triggered if you failed to complete the rollover.
- Failing to confirm the transfer has occurred. Sometimes things go wrong when big companies move money around. When you inform your former employer’s 401(k) provider that you would like to roll the money over, ask how long it typically takes for such rollovers to occur. Once that amount of time has passed, contact the IRA provider to confirm that it’s arrived.
- Failing to invest money that has been rolled over. Rolling money over into an IRA isn’t the final step—you still need to allocate that rolled-over money into investments offered by the IRA provider. Until you do that, your retirement savings are simply sitting in an account not earning anything. Unfortunately, people sometimes overlook this final step and miss out on months of investment profits before realizing their error.
- Counting rollovers as RMDs. Money rolled over from a 401(k) to an IRA does not count toward your required minimum distributions.
- Rolling money into an IRA with a divorce looming—without first consulting a divorce attorney. Whether someone who’s headed toward divorce is better off leaving money in his/her 401(k) or rolling it into an IRA will depend on details hidden deep in the state’s laws and potentially other factors as well. It’s worth consulting an expert before taking action.
