For many a 401k rollover to an IRA is the biggest monetary decision of their life. Imagining transferring the largest sum of money you’ve accumulated from one retirement account to the next.
Are there penalties you should be concerned about. What about taxes? Will you be paying higher fees or surrender penalties with the move?
Everybody out there is covering the ins and outs of Roth IRA rollovers and conversions, including me! They make a lot of sense for a lot of people. But we should never forget about the old reliable traditional IRA. So in this article, I want to cover the how, why and when to do a 401(k) rollover to an IRA, as in a traditional IRA.
As beneficial as Roth IRA conversions are, there really are times when rolling an employer retirement plan into a traditional IRA will work better for you.
Why you might do a 401K Rollover to an IRA
Some 401(k) plans really are excellent. Others are no better than an afterthought – the company offers one, but it sits somewhere between mediocre and just plain lousy.
There are at least five reasons why you might want to do a 401(k) rollover into an IRA, and I’ll bet you can come up with a few more.
1. Direct control over your retirement plan.
If you prefer having direct control over your retirement plan, then you will want to do a 401(k) rollover into an IRA.
Since they are employer sponsored plans, managed by a plan administrator, it can often seem as if there’s an invisible wall around a 401(k).If you’d like easier access to your retirement funds, and less bureaucracy in making decisions, an IRA is a better choice.
2. More investment options.
Many 401(k) plans limit your investment options. They may offer a small number of mutual fund options – such as one index fund, one international fund, one emerging market fund, one aggressive growth fund, a bond fund and a money market fund – plus company stock. If you want to spread your investments to other sectors, or to invest in individual stocks, you will do much better with an IRA account.
Many 401(k) plans limit your investing activities to stock and bond funds.
If you’d like to invest in other asset classes, like commodities or real estate investment trusts (REITs), they have no options. But a self-directed IRA can enable you to invest and trade in virtually limitless investments.
3. You’re unhappy with the investment performance of your 401(k).
If you’ve been watching the market rise by 50% over the last five years, but your 401(k) has risen by only, say 30%, you’re probably anxious to do a 401(k) rollover into an IRA.
Though there’s no guarantee you will be able to outperform the market in an IRA, you’ll at least have a chance to match the market. And if that’s better than what you’re 401(k) plan has been doing for the past few years, it may be time to make a move.
4. Escaping high fees.
401(k) plans can contain – and even hide – a large number of fees. There may be a fee paid to the plan administrator, as well as to the plan trustee, in addition to mutual fund load fees, trading commissions and other charges. In a 401(k) plan, you have no control over the fees.
But by doing a 401(k) rollover into an IRA, you will have greater control. For starters, you will eliminate any fees associated with the plan administrator. But you can also choose to invest through a discount broker, and trading only no load mutual funds and exchange traded funds (ETFs).
The seemingly small 1% or .50% reduction in fees with the IRA could make a huge difference in your long-term investment performance.
5. Consolidation of accounts.
If you have multiple retirement accounts, you’re paying multiple plan fees. But it can also be more difficult to create a comprehensive investment strategy while juggling several accounts. It may be more efficient and less expensive to simply consolidate your various accounts in just one super IRA. That will both lower the cost of retirement investing, and simplify your life.
What are your Rollover Options?
If you leave your employer, you have three basic options in regard to your 401(k) plan:
1. Take a cash distribution now.
This can make sense if you have an immediate acute need for the cash. That can be caused by an extended period of unemployment, or a major medical event.
But you should always avoid taking a cash distribution from any retirement plan for less than a true emergency situation.
Not only will you be depleting an account that was established for the long-term goal of retirement, but there will also be tax consequences. Though the IRS does provide a list of permitted hardship withdrawals, they will only enable you to avoid the 10% early withdrawal penalty. You’ll still have to pay ordinary income tax on the amount of the distribution.
2. Leave the money in the plan.
If you’re satisfied with the plan overall, and particularly with the investment performance, this can make sense. It also has the advantage you may be able to roll it over into the 401(k) plan of a new or future in the employer.
3. Do a 401(k) rollover to an IRA.
You might do this for one, some or all of the five reasons given in the last section. The advantage here is by doing a 401(k) rollover into an IRA, you can take control of the money, but avoid having to pay either income tax or an early withdrawal penalty on the money.
And of course, this option is the main topic of this article.
Traditional Vs Roth IRAs
If you do decide to do a 401(k) rollover to an IRA, your next decision will be whether to do the rollover into a traditional IRA or a Roth IRA.
We’re just going to do a high-altitude review of this topic, since I’ve already written about doing a 401(k) rollover to a Roth IRA. We’ll review the basics on traditional vs. Roth IRAs here, but then we’ll get back to the main focus of this article, which is doing a 401(k) rollover into a traditional IRA.
Let’s keep it simple by looking at the pros and cons of doing a rollover into each type of IRA.
- You can do a full 401(k) rollover to an IRA without any tax consequences
- Future contributions to a traditional IRA are generally tax-deductible
- This option makes greater sense if you fully expect to be in a lower tax bracket in retirement than you are in right now (defer high, withdraw low – tax rates, that is)
- Distributions from a traditional IRA are taxable upon withdrawal.
- Required minimum distributions (RMDs) must begin at age 70 1/2, forcing you to slowly liquidate the plan, and incur tax liabilities as you do.
- This option will make little sense if you will be in the same or higher tax bracket in retirement than you are right now.
- You can take tax-free distributions from a Roth IRA as long as you are at least 59 and 1/2, and the Roth plan has been in existence for at least five years.
- RMDs are not required on a Roth IRA; this is the only type of retirement plan that does not require them. This can enable you to continue growing your plan for the rest of your life, and even reduce the possibility you will outlive your money.
- A Roth IRA is an excellent strategy if you expect your tax bracket in retirement to be equal to or higher than it is right now.
- Distributions from a Roth IRA will not increase the amount of your Social Security benefit that will be taxable.
- You will have to add the amount of your 401(k) rollover to a Roth IRA to your income in the year(s) of the conversion(s). The amount of the rollover will be subject to ordinary income tax, though not the 10% penalty for early withdrawal.
- The amount of the conversion could push you into a higher tax bracket, say from 15% up to 25%, or even 33%.
- The conversion will make less sense if you expect a much lower tax bracket in retirement.
It may be a poor exchange if you pay 33% tax at conversion, in order to be exempt from a 15% tax rate in retirement!
Just know if you decide to do a 401(k) rollover to a Roth IRA, you will have to do a Roth IRA conversion. It’s a more complicated variety of the standard 401(k) rollover to an IRA, but it’s well worth the extra effort if you decide a Roth IRA will work better for you.
Direct Vs Indirect 401K Rollover to an IRA
I like to think of this as a safety issue more than anything else. No kidding – get this wrong and it can cost you thousands in taxes and penalties!
A direct rollover, also known as a trustee-to-trustee transfer, is where the balance your 401(k) plan goes directly into your IRA. This is the simplest type of rollover, since the money goes from one account to the other, with no involvement or responsibility on your part.
What’s more, since the money is going from one retirement plan to another, there will be no tax withholding. 100% of the 401(k) balance will go directly into the IRA account.
An indirect rollover is where the distribution from the 401(k) plan goes to you first. From there, you move the money into an IRA account.
There are two problems with this type of rollover, and they are big:
- Withholding taxes – since the distribution from the 401(k) plan is going directly to you, the plan administrator is generally required to withhold an allowance for taxes. It’s either 10% or 20% of the amount of the distribution.
- You must complete the transfer of the 401(k) distribution funds to an IRA account within 60 days, otherwise the entire distribution will become subject to both income tax and, if you are under age 59 1/2, the 10% early withdrawal penalty.
I want to spend a few minutes on the first problem. If the 401(k) administrator withholds income taxes on your indirect rollover, the amount of cash you will have available to transfer to the IRA account will be less than the full amount of distribution. Got that?
If you do an indirect transfer of $100,000 from your 401(k) plan, with the intention you will move the money to an IRA within 60 days, the plan administrator will withhold 20% for income taxes. That means while you have taken a distribution of $100,000, you have only $80,000 to transfer over into the IRA.
This will leave you with one of two outcomes, and neither is any good:
- You will have to add $20,000 of non retirement cash to the IRA transfer, in order to make the full amount of the rollover, or
- You will rollover just $80,000, and the $20,000 that didn’t make it into the IRA because of the withholding taxes, will be subject to ordinary income tax, and possibly a 10% early withdrawal penalty.
And if some reason – whatever it is – none of the $100,000 from the indirect rollover makes it into the IRA the entire amount will be subject to both ordinary income tax and if you are under age 59 1/2, the 10% early withdrawal penalty.
No good can come from doing an indirect rollover, but a lot of bad stuff can happen.
My best advice: pretend the indirect rollover option doesn’t exist, and just do a direct 401(k) rollover to an IRA. That’ll make a mistake or miscalculation impossible.
Choosing your IRA - Managed or Self Directed?
If you have decided to do a 401(k) rollover to an IRA and you’ve (wisely) chosen to do a direct rollover, the next step is to think about what type of IRA account you want as the destination for your retirement money.
Probably the first question you need to answer is whether or not you want a managed account for a self-directed account.
A managed account is where you turn the account over to an investment manager, who handles all of the details of investing for you. The manager or investment platform creates a portfolio, purchases the securities and funds that make it up, re balances periodically, reinvests dividends, and buys and sells investment positions as needed. They handle everything for you, while you take care of the everything else in your life.
A self-directed account is just what the name implies. It generally works best with a discount broker, and you make all of your own investment decisions.
Which type of account should you choose?
A managed account makes sense under the following circumstances:
- If you have little or no investment experience
- Have a bad track record of managing your own investments
- Aren’t really interested in the mechanics of investing
- Have a busy life, and no time for investing
- You’re comfortable having someone else manage your money for you
A self-directed account works better if…
- You’re an experienced investor
- You’re comfortable with your ability to invest successfully
- You have a deep interest in investing
- You have the time and temperament to manage your own investments
- You don’t trust anyone else can do a better job managing your investments
Think long and hard about which account type will work best for you. It takes many years to build up a large retirement nest egg, but only a few bad investment decisions to crush it.
Let your 401K Plan Administrator and your IRA Advisor do all the work
Most of us don’t do enough retirement plan rollovers to be experts. So if you decide you want to do a 401(k) rollover to an IRA, it’s best to turn the process over to both your current 401(k) plan administrator and your new investment advisor. Since both are “in the business”, they’ll know exactly how to make it happen.
Your best friend in the rollover process is likely to be your new advisor. It’s usually better to already have an IRA account in place, but opening up a new IRA isn’t at all difficult.
In a rollover situation, you simply need to tell the new advisor you want to do a rollover. They will request certain information from you, including contact information of your 401(k) plan administrator.
They will also have you sign certain documents that will enable them to make the transfer. From there, they will handle the transfer, including contacting your 401(k) plan administrator.
The you should involve the 401(k) plan administrator in the process too, but they may provide only varying degrees of help. After all, you’ll be leaving their plan, so they may be less than enthusiastic about helping you. And some plan administrators may be reluctant to help at all.
The best strategy is to allow the advisor to take the lead in the process, and to involve the 401(k) plan administrator only where necessary!
In the best of transactions, you will answer some questions and sign some forms at the very beginning, and then the transfer will be handled between the two plans.
Why you might not want to do a 401K Rollover
In most cases, doing a 401(k) rollover to an IRA will be the right choice. But at the same time, no discussion of a 401(k) rollover to an IRA would be complete if we didn’t also spent some time on why you might not want to do this kind of rollover.
What are some reasons why you might choose to keep your 401(k) plan exactly where it is, even though you no longer work for the company?
- You’re perfectly happy with everything about the plan, including the performance, the investment selections, and the structure.
- The 401(k) plan you have is comparable in most or all respects to whatever type of IRA account you would roll over into.
- Your 401(k) plan is being professionally managed, but without the professional investment management fee.
- Creditor/lawsuit/bankruptcy protection – 401(k) plans are protected from all three under federal law, but IRAs may or may not be protected by state law. If the laws in your state don’t protect your IRA, you may be better off leaving the money in the 401(k) plan.
- 72(t) distributions – if you lose your job or take early retirement at or after turning 55, you can take penalty-free distributions from a 401(k) plan, but not from an IRA.
- You might be able to transfer your old 401(k) plan to the 401(k) plan of a new employer, which is generally not the case with IRA accounts.
- RMDs don’t apply to a 401(k) if you are still working after age 70 1/2. They will be required on IRA accounts.
There’s one other situation that’s highly specialized, though not uncommon. It applies when you have a large amount of employer company stock in your 401(k) plan.
It’s the net unrealized appreciation rule, or NUA.
It works like this:
If you have a large amount of company stock in your 401(k) plan, and you do a full rollover into an IRA, any distributions taken from the IRA will be subject to ordinary income tax rates. If you take the distributions before turning 59 1/2, you’ll also have to pay a 10% early withdrawal penalty.
If on the other hand you leave the company stock in your 401(k) plan, you’ll get a special benefit – the NUA.
When you take a distribution that includes the company stock, you will have to pay tax only on the amount you paid for the stock. Any gain on the stock will then be taxable at the more favorable capital gains tax rate, which can be as low as zero, but no higher than 20%.
If you have a large amount of company stock, and there is a substantial amount of appreciation on the stock, it’s best to keep the stock in the 401(k) plan, and do a 401(k) rollover to an IRA only of the non-company stock assets in the 401(k) plan.
Summarizing the 401k Rollover
Despite the long list of reasons not to do a 401(k) rollover to an IRA, or the solid reasons to do a conversion into a Roth IRA, there really are a lot of times when doing the rollover into a traditional IRA is the best strategy.
Evaluate your 401(k) plan, as well as your own preferences and investment objectives, and then compare these with the benefits a traditional IRA account provides. And don’t be afraid to discuss the rollover options in some detail with a trusted investment advisor like us.
You worked long and hard to build up your 401(k) plan, and one day will be one of the primary ways you’ll survive. You owe it to yourself to carefully consider which option will best accomplish that goal.