Did you know that your 401(k) is tied to the stock market and is in risk of a stock market crash? It offers no diversity, no opportunity to invest in other assets like precious metals or real estate, and very risky when it comes to losing all of your hard earned savings.
Fortunately for you, this article will cover the ways that you can rollover this account to an IRA.
What are the choices with a 401(k) distribution?
When you have a 401(k) with an employer and you decide to leave the company, you have four basic options:
Cash out the plan
If you choose this option, you simply direct the plan trustee to liquidate the account and send you a check. The account will be closed out, and no further action is necessary.
Advantages: If the balance in the plan is relatively small, like a few thousand dollars, you may decide the money would be better used to pay off debt.
This can make sense if the tax liability on the distribution isn’t too high, and the interest you’re paying on the debt you intend to pay off is much higher than the investment return in the 401(k).
Disadvantages: You’ll have to pay ordinary income tax on the amount of the distribution, which won’t make sense if you’re in anything higher than the 12% tax bracket.
But if you’re under 59 ½ you’ll also have to pay the IRS 10% penalty on early distributions.
Keep the 401(k) with the previous employer
This is the simplest choice of all. You decide to do nothing, and leave the account where it is. Unless the employer has some sort of rule requiring disposition of the account following separation, you can literally leave the money in the plan for the rest of your life.
Advantages: No action is required on your part. If you’re satisfied with the investment options in the plan, as well as the plan performance, there’s no need to move the money.
Disadvantages: Not a good idea if you’re not happy with the investment options or with the performance of the plan.
The plan may also have high fees, including an annual account maintenance fee, that will further hurt your investment performance.
Roll the previous employer 401(k) into the new employer’s plan
This is where you transfer the 401(k) from your previous employer sponsored retirement plan to the new one. Once the transfer is complete, you’ll have access to all the investment options of the new plan.
Advantages: Good strategy if the new employer plan has either greater investment options, lower fees, or both, compared to the old plan.
Disadvantages: The new employer may not permit rollovers, or it may not even offer a plan to roll the previous 401(k) into.
Also a bad strategy if the new employer plan has more limited investment options and/or higher fees than the previous employer plan.
Do a 401(k) rollover to an IRA
Instead of rolling over the old 401(k) to a new employer plan, you choose instead to do a 401(k) rollover to an IRA.
Advantages: You can transfer the funds from the old 401(k) to a self-directed IRA.
This will give you potentially unlimited investment options and lower fees, since you will choose the trustee for the plan.
This can be a diversified investment broker where you can trade any investments you like, or a managed plan, like a robo-advisor.
Disadvantages: Not a good idea if you’re not comfortable making your own investment decisions.
But then you always have the option to have your account fully managed at very low cost by a robo-advisor.
Also be aware you may lose certain legal protections by moving the funds from an employer sponsored plan to a self-directed plan (more on that under The Disadvantages of a 401(k) Rollover into an IRA.)
Advantages
The main advantage of a 401(k) rollover to an IRA can be summed up in one word: control.
The control factor with an IRA can be broken down as follows:
- You choose the plan trustee. You can hold the account with any investment platform you feel most comfortable with. That may be because it offers 24/7 customer service, top-notch investment tools and research, or even local branch offices.
- Invest your way. Some employer plans limit you to a few funds. With an IRA provider, you can invest in an unlimited number of funds, as well as stocks, bonds, options, real estate, precious metals, and even options. You can also choose a managed option with a robo-advisor.
- Control over fees. With most major investment brokers now charging no trading fees, and robo-advisors managing portfolios for just a fraction of 1%, you can reduce your investment fees very close to zero.
- Access to your funds. To avoid tax consequences, you should refrain from taking early distributions from a retirement fund. But if you absolutely need to access the funds, that’s far easier to do with an IRA than with an employer sponsored plan – although we always suggest talking to a tax advisor if you find yourself in this position.
- Roth IRA option. You can convert some or all of your IRA balance to a Roth IRA whenever you choose. A Roth IRA has the advantage of distributions being tax-free in retirement, and also having no required minimum distributions (RMDs) after age 70 1/2 . Though some employer plans offer a Roth 401(k) option, most don’t.
Disadvantages
Rolling over a 401(k) into an IRA does have some disadvantages, so you’ll have to weigh these against the advantages.
- Early separation from service. All retirement plans discourage you from taking withdrawals before reaching the age of 59 ½. That’s what the 10% early withdrawal penalties are all about. But the penalty is waived on distributions taken from a 401(k) plan as early as 55 under the separation from service exemption. This exemption does not apply to IRA accounts.
- Greater legal protections for employer plans. As ERISA plans, 401(k) plans are generally protected from creditors, civil judgments and bankruptcy proceedings. However, under federal bankruptcy laws, up to $1,362,800 in traditional and Roth IRAs are protected in bankruptcy proceedings. And in most states (but not all), IRAs are also protected from creditors.
- Convertibility to a future employer plan. While you can generally roll over a previous employer 401(k) to a new employer plan, the same is not generally true with an IRA.
- You’re happy with the investment performance of your existing plan. If you don’t have much investment experience, and you’re satisfied with the returns on your old 401(k), moving the money to an IRA may not be in your best interest.
Traditional IRA vs. Roth IRA
Let’s say that after evaluating the advantages and disadvantages of doing a 401(k) rollover to an IRA, you decide to move forward with the rollover.
Now you have a second choice: traditional IRA or Roth IRA.
Traditional IRA
The traditional IRA has all the advantages and disadvantages we’ve discussed so far. The main advantage to doing a 401(k) rollover to a traditional IRA (compared to a Roth IRA) is that there are no tax consequences as a result of the rollover.
You’ll move the old 401(k) to your traditional IRA, report it on your tax return as a full rollover, and you will not ordinary owe income tax, and no 10% early withdrawal penalty.
You’ll be able to keep the money in the traditional IRA, building up tax-deferred investment income. After age 59 ½ you can begin taking withdrawals from the plan.
Roth IRA
If you do a rollover of a 401(k) to a Roth IRA, you’ll experience financial pain at the time of the rollover, but you’ll gain many benefits in the future.
That’s because a rollover from a 401(k) to a Roth IRA creates a tax liability. The full amount of the 401(k) – less any after-tax contributions – will be subject to ordinary income tax, but not the 10% early withdrawal penalty.
IRA Rollover Fees
If you do opt for a self-directed IRA account, there may be some fees to be aware of. However, self-directed IRA fees are almost always lower than 401(k) fees.
Examples include:
- Annual fee. This may go by different names, such as an administrative fee, and may be something like $50 per year. But most IRA trustees don’t charge this fee.
- Trading commissions. Most major brokerages have waived these fees on trades of stocks, exchange traded funds (ETFs) and options. But many still charge trading fees on mutual funds and some other investments.
- Load fees. These are sales charges on mutual funds, and they can be as high as 3%. However, many mutual funds are no-load, and you can avoid the fee by holding these funds.
- Management fees. These apply to managed funds, like robo-advisors. They generally charge an annual fee to manage your portfolio, ranging from 0.25% to 0.50%. For example, if you have $100,000 in the plan, and the robo-advisor fee is 0.25%, you’ll pay $250 per year, which is usually pro-rated on a monthly basis.
- Expense ratios. These are the fees charged by funds for administrative and marketing expenses. Called 12b-1 fees they can be as high as 1% annually. But you can find many funds that charge less than 0.20%. You don’t pay this fee separately. Rather it’s an internal fee, charged within the fund, thus reducing it’s net return.
How to Do a 401(k) Rollover to an IRA
There are two ways to do a 401(k) rollover to an IRA. The first is a direct rollover. This is where the funds from your 401(k) plan are transferred directly to your account with the new IRA trustee.
The second is an indirect rollover. This is where the funds from the 401(k) are sent to you personally, then you transfer them into your IRA account.
Under IRS rules, you have up to 60 days to complete the transfer, otherwise the funds transferred to you will be considered a distribution of the 401(k) plan funds.
The best option is the direct rollover method. It completely avoids the possibility you’ll miss the 60 rollover window and be subject to a plan distribution and the income tax bill consequences that will invite.
Contact your new IRA trustee, and direct them to handle the rollover for you.
They have experience in this capacity, and know exactly what to do. They’ll contact the appropriate party with your 401(k), and arrange for the transfer to take place smoothly.
Should I do a 401(k) rollover to an IRA?
The 401(k) rollover to an IRA has become very popular, and for good reason. Today’s retirement plans are designed to be portable, and none are more so than an IRA.
Once you complete the rollover, you’ll have more choices than you ever had with your 401(k). That will include the choice of the plan trustee, the type of investing you’ll do, and even the account fees you’ll pay.
Complete flexibility is usually a big advantage when it comes to investing, especially for retirement. And while you’re managing your new rollover IRA account, you’ll be building a whole new 401(k) plan with your new employer.
It’ll be the best of both worlds.