Pros and Cons of Rolling Your 401(k) Into an IRA

When you leave a job, you pack up your family photos, the spare pair of dress shoes stashed under your desk, your “I Love My Corgi” coffee mug and all your other personal items. But what do you do with your 401(k) plan?

Most people roll the money over to an IRA because they gain access to more investment options and have more control over the account. Some brokerage firms sweeten the deal with cash incentives. TD Ameritrade, for example, offers bonuses ranging from $100 to $2,500 when you roll over your 401(k) to one of its IRAs, depending on the amount. Plus, moving your money to an IRA could help you streamline your investments. Amy Thomas, a 43-year-old clinical trial coordinator in Lakewood, Colo., has rolled over 401(k) plans from three former employers into one place, which “makes everything a lot easier,” she says. Now she doesn’t worry that she’ll lose track of an account that might have been left behind.

But a rollover isn’t always the right move; sometimes it’s best to simply leave the money where it is. With millions of dollars to invest, large 401(k) plans have access to institutional-class funds that charge lower fees than their retail counterparts. That means you could end up paying less to invest in the 401(k). There are other perils to a rollover: If you’re not careful, you could end up with a portfolio of high-cost investments with subpar returns, an issue that’s in the spotlight as a result of the debate surrounding the proposed fiduciary rule.What about cashing out the account when you leave your job and taking a lump sum? Unless your financial situation is dire, that’s never a good idea. You’ll owe taxes on the entire amount, plus a 10% early-withdrawal penalty if you’re younger than 55.

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Reasons to roll over

Rolling over the money from your 401(k) to an IRA is still the best move in many cases.

Your plan has high-cost investments. Many large 401(k) plans offer low-cost options that have been carefully vetted by the plan’s administrators, but other 401(k)s are hobbled by underperforming funds and high costs. And even low-cost plans may charge former employees higher administrative fees if they choose to keep their 401(k).

Some plans offered by small and midsize companies are loaded with insurance products that charge “egregious” fees, says Mitch Tuchman, managing director of Rebalance IRA, which provides advice and low-cost investment portfolios for IRA investors. Rebalance invests clients’ money in exchange-traded funds to keep costs down. (For advice on how to create a low-cost portfolio of index and actively managed funds.

Companies are required by law to disclose the fees they take out of your account to pay for administrative costs. Review your quarterly statements for details. Companies are also required to provide an annual rundown of the plan’s investment costs, expressed as a percentage of assets, or an expense ratio. You can use this information to see how your retirement plan’s mutual fund expenses compare with the expense ratios of similar funds. Average expense ratios for retirement plans have declined, partly because plans feature more index mutual funds. The average fee is 0.68% for stock funds and 0.54% for bond funds, according to a 2015 survey by the Investment Company Institute. To see how your plan compares with other employer-sponsored plans, check out www.brightscope.com.

You have a trail of 401(k) accounts. If you’ve changed jobs frequently—younger baby boomers switch jobs an average of 12 times during their careers, according to the Bureau of Labor Statistics—leaving your plan behind could result in a mishmash of overlapping funds that may not suit your age and tolerance for risk. In that case, it can make sense to consolidate all of your old 401(k) plans in an IRA. Another option is to roll 401(k) accounts from former employers into your current employer’s plan, assuming that’s permitted.

You need more bond funds. Although most 401(k) plans have a solid lineup of stock funds, they’re often much weaker when it comes to fixed-income options, says Melissa Brennan, a certified financial planner in Dallas. In many cases, says Brennan, choices are limited to a money market fund, a bond index fund and an actively managed bond fund. Most plan trustees are focused on encouraging participants to accumulate as much as they can—which typically involves investing in stocks. As you get close to retirement, though, you’ll probably want to shift to a less-aggressive mix of investments. Rolling your money into an IRA will provide you with a smorgasbord of fixed-income options, from international bond funds to certificates of deposit.

You want flexibility for withdrawals. About two-thirds of large 401(k) plans allow retired plan participants to take withdrawals in regularly scheduled installments—monthly or quarterly, for example—and about the same percentage allow retirees to take withdrawals whenever they want, according to the Plan Sponsor Council of America, a trade group. But other plans still have an “all or nothing” requirement: You either leave your money in the plan or withdraw the entire amount. In that case, rolling your money into an IRA will enable you to manage your withdrawals and taxes you’ll pay on them.

Even if your 401(k) plan allows regular withdrawals, an IRA could offer more flexibility. Many 401(k) plan administrators don’t let you specify which investments to sell; instead, they take an equal amount out of each of your investments, says Kristin Sullivan, a certified financial planner in Denver. With an IRA, you can direct the provider to take the entire amount out of a specific fund and leave the rest of your money to continue to grow.

Stick with the 401(k)?

In addition to lower costs, many 401(k) plans offer stable-value funds, a low-risk option you can’t get outside of an employer-sponsored plan. With recent yields averaging about 1.8%, stable-value funds provide an attractive alternative to money market funds. And unlike bond funds, they won’t get pulverized if interest rates rise. Other good reasons to leave your money behind:

You plan to retire early…or late. In general, you must pay a 10% early-withdrawal penalty if you take money out of your IRA or 401(k) before you’re 59½. There is, however, an important exception for 401(k) plans: Workers who leave their jobs in the calendar year they turn 55 or later can take penalty-free withdrawals from that employer’s 401(k) plan. But if you roll that money into an IRA, you’ll have to wait until you’re 59½ to avoid the penalty unless you qualify for one of a handful of exceptions. Keep in mind that you’ll still have to pay taxes on the withdrawals.

Another wrinkle in the law applies to people who continue to work past age 70, which is increasingly common. Ordinarily, you must take required minimum distributions from your IRAs and 401(k) plans starting in the year you turn 70½. These distributions are based on the value of your accounts at the previous year’s end and on a life-expectancy factor found in IRS tables. But if you’re still working at age 70½, you don’t have to take RMDs from your current employer’s 401(k) plan. And if your plan allows you to roll over money from a former employer’s plan into your 401(k), you can also protect those assets from RMDs until you stop working.

You want to invest in a Roth IRA but earn too much to contribute. Rolling over your former employer’s 401(k) to an IRA could make it more expensive to take advantage of a strategy to move money into a Roth IRA.

You must pay taxes on your contributions to a Roth IRA, but withdrawals will be tax-free when you retire. But in 2017, if you’re single with adjusted gross income of more than $133,000 or married filing jointly with AGI of more than $196,000, you can’t contribute directly to a Roth. There’s no income limit, though, on Roth conversions, which has given rise to the “backdoor” Roth IRA. High earners can make after-tax contributions to a nondeductible IRA—in 2017, the maximum contribution is $5,500, or $6,500 if you’re 50 or older—and then convert the money to a Roth. Because the contributions to the nondeductible IRA are after tax, there is usually no tax on the conversion.

Unless, that is, you already have money in a deductible IRA—which you certainly will if you roll over your former employer’s 401(k) into an IRA. In that case, your tax bill will be based on the percentage of taxable and tax-free assets in all of your IRAs, even if you convert only one of them. For example, if you have $5,000 in a nondeductible IRA and $95,000 in a deductible IRA and convert $50,000 to a Roth, then only 5% of the nondeductible IRA funds, or $250, will be tax-free; you’ll owe tax on the rest. (If your employer offers a Roth 401(k), you can avoid this rigmarole because there are no income limits on contributions.)

You’re worried about lawsuits. The federal Employment Retirement Income Security Act (ERISA) shields 401(k) and other types of employer-sponsored retirement plans from creditors. If someone wins a judgment against you in a personal injury lawsuit, he can’t touch your 401(k) plan. IRAs don’t offer that same level of protection. They’re generally protected if you file for bankruptcy, but state laws vary with respect to other types of claims. California, for example, exempts the amount necessary to support you and your dependents in retirement. For physicians, protecting retirement savings from creditors “is a very big issue,” says Daniel Galli, a certified financial planner in Norwell, Mass.

Protect your assets

Concerns that some securities brokers and insurance company representatives were encouraging investors to roll their 401(k) plans into high-cost or inappropriate investments that generated big commissions was one reason the U.S. Department of Labor proposed new requirements for financial professionals who advise investors with retirement accounts. The DOL rule would require those individuals to comply with the fiduciary standard, which means they would be required to put their clients’ interests above their own. Securities brokers now adhere to a less-stringent suitability rule. Investments they recommend must be suitable, given a client’s age and risk tolerance, but they don’t have to be the lowest-cost alternative.

For now, the fiduciary rule is on hold. The Trump administration has instructed the Department of Labor to review the rule, which could lead to its demise. Critics, which include some securities industry groups, have said that the rule would make it more difficult for middle-income savers to get advice.

But in anticipation of the rule, which was scheduled to take effect in April, financial services firms have made a raft of changes that they’re unlikely to reverse (see Why the Fiduciary Rule for Retirement Savers Is Here to Stay). Some big firms have scrapped commission-based IRAs in favor of charging fees based on a percentage of assets. In addition, a host of financial services companies, such as Betterment, LearnVest and Personal Capital, have harnessed technology to offer affordable, objective advice, even if you have only a modest amount to invest.

No matter what happens in Washington, you are your own best advocate. Ask prospective advisers why they’re recommending a particular investment and how they’ll be compensated for it. Don’t let anyone steamroll you into rolling over your 401(k) to an IRA. “It seems like everybody and their brother is interested in rolling money out of your 401(k),” says Daniel Galli, a certified financial planner in Norwell, Mass. But, says Galli, there’s no downside to leaving your money in your former employer’s plan while you consider your options.