The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.
After leaving your job, you’ll have to decide whether or not you want to roll your 401(k) over to an IRA. For the most part, the answer is easy: Yes, roll over your 401(k).
Better Investment Options in an IRA
Reducing your investment costs is one of the most reliable ways to improve your investment returns. Unfortunately, many 401(k) plans have only one low-cost investment option: an S&P 500 index fund. (And some plans don’t even have that much!) This forces you to either:
- Use subpar (i.e., high-cost) mutual funds for the remaining portions of your portfolio (bonds, international stocks, small cap stocks, etc.), or
- Overweight the S&P index fund in order to keep costs down (thereby throwing your asset allocation out of whack).
In contrast, with an IRA, you’ll have access to a wide array of low-cost investment options in every asset class.
Lower Fees in an IRA
In addition to limiting you to high-cost funds, most 401k plans include an administrative fee. A 2009 study by Deloitte and the Investment Company Institute found the median admin fee to be 0.72% of assets annually.
In contrast, many brokerage firms charge no annual IRA fees at all.
Between less expensive investment options and lower administrative costs, it’s likely that you can reduce your total investment costs by 1% per year simply by moving your money from a 401(k) to an IRA. That might not sound like much, but when compounded over your whole retirement, improving your investment return by 1% can have a dramatic impact on how long your money lasts.
Try thinking of it this way: If you plan to use a 4% withdrawal rate from your portfolio, paying investment costs of 1% per year would mean that you can only actually spend 3% of your portfolio value–that’s a 25% reduction in your ability to spend!
Reasons Not To Roll Over a 401(k)
There are, however, a few specific situations in which it doesn’t make sense to roll over a 401(k)—or other employer-sponsored retirement plan—after leaving your job.
If you are “separated from service” (i.e., you leave your job, were laid off, etc.) at age 55 or later, distributions from your 401(k) will not be subject to the 10% additional tax that normally comes with retirement account distributions before age 59½.
As a result, if you are 55 or older when you leave your job and you plan to retire prior to age 59½, it may make sense to put off rolling your 401(k) into an IRA until you are 59½. This way, if you need to spend some of the money prior to age 59½, you can do so without having to worry about the 10% additional tax.
Planning a Roth Conversion?
If you currently have a traditional IRA to which you made non-deductible contributions and you are planning a Roth conversion, you may want to hold off on rolling over your 401(k) until the year after you’ve executed the Roth conversion, so as to minimize the portion of the conversion that’s taxable.
Does Your 401(k) Include Employer Stock?
If your 401(k) includes employer stock that has significantly appreciated in value from the time you purchased it, you’d do well to speak with an accountant before rolling over your 401(k). Why? Because under the “Net Unrealized Appreciation” rules, you may be able to take a lump-sum distribution of your 401(k) account, moving the employer stock into a taxable account and rolling the rest of the account into an IRA.
Why would such a maneuver be beneficial? Because, if you roll the stock into a taxable account, only your basis in the stock (i.e., the amount you paid for it) will be taxed as a distribution. The amount by which the shares have appreciated in value (the “Net Unrealized Appreciation”) isn’t taxed until you sell the stock. And even then, it will be taxed at long-term capital gain tax rates (currently, a max of 15%) instead of being taxed as ordinary income.
In contrast, if you roll the stock into an IRA, when you withdraw the money from the IRA, the entire amount will count as ordinary income and will be taxed according to your ordinary income tax bracket at the time of withdrawal.
Example: Martha recently retired from her job with a utility company. She owns employer stock in her 401(k). The stock is currently worth $100,000. The total amount she paid for the shares was $42,000.
- If she rolls her entire 401(k) into an IRA, when she withdraws that $100,000, the entire amount will be taxable as ordinary income.
- If, however, she rolls the employer stock into a taxable account, she’ll only be taxed upon her basis in the shares ($42,000). And when she eventually sells the shares, the gain will be taxed as a long-term capital gain (at a maximum rate of 15%) rather than as ordinary income.
Remember, though, that holding a significant amount of your net worth in one company’s stock is risky—especially when that company is your employer. Be careful not to take on too much risk in your 401(k) solely in the hope of getting a tax benefit in the future.
How to Roll Your 401(k) Into an IRA
In most cases, rolling over a 401(k) is just four easy steps:
- Open a traditional IRA if you don’t already have one,
- Request rollover paperwork from your plan administrator,
- Fill out the paperwork and send it back in, and
- Once the money has arrived in your IRA, go ahead and invest it as you see fit.
When you’re filling out the paperwork, you’ll want to initiate a “direct rollover” (sometimes called a “trustee-to-trustee” rollover). That is, do not have the check made out to you. Have it made out to—and sent to—the new brokerage firm.
If for some reason the check arrives in your own mailbox, don’t panic. But be sure to forward the check to the new brokerage firm ASAP. If you don’t get it rolled over into your new IRA within 60 days, the entire amount will count as a taxable distribution this year, which would likely result in a hefty tax bill.
Where to Roll Over Your 401(k)
In terms of where to roll over your 401(k), you have three major options. You can roll your 401(k) account into an IRA account at:
- A mutual fund company,
- A discount brokerage firm, or
- A full service brokerage firm.
Rolling a 401(k) into an IRA account with a mutual fund company can be a good choice. As long as you make sure to choose a fund company that has low-cost funds, low (or no) administrative fees for IRAs, and a broad enough selection of funds to build a diversified portfolio, you should do just fine. For example, Vanguard has excellent index funds and would be a great place to roll over a 401(k).
Your second option is to roll your 401(k) account into an IRA account at a discount brokerage firm, such as Charles Schwab or Fidelity. Due to the proliferation of exchange-traded funds (ETFs), you can now quickly and easily create a low-cost, diversified portfolio at any discount brokerage firm.
Option #3—using a “full service” brokerage firm—is one I’d generally recommend against. At these companies, brokers (calling themselves Financial Advisors) make a living by repeating this process:
- Track down somebody with a 401(k) account to roll over,
- Convince him to roll it into an IRA account at their firm, and
- Once it’s rolled over, sell the investor a portfolio of mutual funds with steep up-front sales loads.
To name names: At companies like Morgan Stanley Smith Barney, Merrill Lynch, Wachovia, UBS, or Edward Jones, a financial advisor will usually try to sell you a portfolio of funds with front-end commissions (a needless cost) or an advisory account with unnecessarily high ongoing fees.
- In most cases, it’s beneficial to roll your 401(k) into an IRA after leaving your job. Doing so will give you access to better investment options and will likely reduce your administrative costs as well.
- If you left your job at age 55 or older, and you plan to retire prior to age 59½, you may want to postpone rolling over your 401(k) until you reach age 59½.
- If you’re planning a Roth conversion of non-deductible IRA contributions, you may want to hold off on a 401(k) rollover until the year after your Roth conversion is complete.
- If you have employer stock in your 401(k), before rolling your 401(k) into an IRA, it’s probably a good idea to speak with an accountant to see if you can take advantage of the Net Unrealized Appreciation rules.
- In most cases, the best place to roll over a 401(k) is a mutual fund company with low-cost funds or a discount brokerage firm that offers low-cost (or no-cost) trades on ETFs