Should I Rollover My Old 401K?
After changing jobs, many wonder what to do with a 401k account at their former employer. While some make the mistake of simply withdrawing their 401k balance (not advisable since it involves paying taxes and likely early withdrawal penalties as well), there are three practical alternatives:
- Leave the assets in the former employer’s 401k plan;
- Transfer the assets to a new employer’s 401k plan (if permitted by the new employer) or,
- Transfer the assets to an IRA rollover account.
Each of these options has pros and cons, and there is no single correct decision for all account holders. The following are some factors to weigh in deciding which option is best for you.
Converting a 401K account into an IRA Rollover usually increases investment flexibility. Most 401K plans are constrained to a set menu of mutual funds or target-date funds. While some plans have an extensive roster of low-cost funds covering a wide range of asset classes, others offer only a limited selection of high-cost funds. Switching to an IRA rollover broadens the investment options to include individual stocks & bonds, preferred stocks, exchange-traded funds (ETFs), closed-end funds (CEFs), and other niche asset classes. One caveat: some 401k plans may have “grandfathered” access to mutual funds, which are otherwise closed to new investors (and would be unavailable to retail investors with an IRA rollover account).
Participants in company-sponsored plans usually pay two types of fees, each of which can be difficult to discern. First, there is the expense ratio of the funds in the plan. This can range from a few basis points (one-hundredth of 1%) on a large index fund to more than 100 basis points on an actively managed fund. Most 401k plan administrators disclose fund expense ratios. Still, some are opaque (fund families can further obscure this information by using alternate share classes of a fund).
Second, every 401K has administrative expenses, which are generally apportioned among the participants and can vary widely depending on the size of the plan (and implicitly, the negotiating power of the employer with the fund administrator). While the sponsoring employer may subsidize some (or all) of a 401k’s administrative costs, they are not required to. Thus, a former employee who no longer actively contributes to a 401K plan will continue to bear their proportional share of its administrative expenses.
On the other hand, an IRA rollover may also incur fees, such as custodial maintenance fees (generally waived with a minimum balance), brokerage commissions (also becoming less common), and management fees (if working with an advisor).
Expected Retirement Age
Nominally, both IRAs and 401ks levy a 10% tax penalty for withdrawals before age 59.5, yet each allows several exemptions to this rule. IRA account holders can avoid the 10% penalty via a series of “Substantially Equal Periodic Payments” (often abbreviated as “SEPP” or “Rule 72t”). 401k account holders can avoid the 10% tax under the “Rule of 55,” which allows for penalty-free withdrawals from a 401k upon separation for any reason (fired, laid off, voluntary retirement, etc.) beginning in the calendar year in which the account holder turns 55 (or age 50, in the case of certain public sector employees). Importantly, the Rule of 55 only applies to the specific 401k or 403b plan at the employer from which the participant most recently separated.
While the SEPP rule is somewhat stringent and allows for little subsequent modification, the Rule of 55 is much more flexible on the timing and amount of withdrawals. For this reason, high net worth investors contemplating an earlier retirement sometimes consolidate their retirement assets in the 401k plan of their final employer to permit early access to those funds. Similarly, while both IRAs and 401ks require account holders to begin making withdrawals at age 72, 401k participants who are still working (and own less than 5% of the firm where they are employed) are allowed to delay their RMD from the 401k. Thus, those who expect to work beyond age 72 can maximize tax deferrals by consolidating retirement assets in their current employer’s 401k plan.
Automatic Tax Withholding
401k plans are regulated under the ERISA Act (1974) and consequently have stringent rules regarding distributions. For example, unless a 401k participant specifies that their distribution is a “direct custodian rollover,” the 401k plan administrator must withhold 20% for taxes. In contrast, an account holder with an IRA rollover (assuming they have reached age 59.5) can elect to make distributions without having any taxes withheld. This greater tax flexibility is why investors who expect to retire between age 59.5 and 72 often prefer to consolidate their assets in an IRA rollover.
Assets held in a 401k have greater protection against creditors or legal judgments than assets held in an IRA. A 401k is covered by federal ERISA law, which exempts the assets from creditor claims. However, IRA accounts are governed by state laws, which offer varying levels of asset protection. If an investor resides in a state with weaker IRA protections, they may find it worthwhile to maintain their assets in a 401k instead.
Company Stock in a 401k
Suppose you own shares of highly appreciated company stock within your 401k. You may want to avoid rolling those shares into an IRA, as you could potentially save much more on taxes by moving the shares into a (taxable) brokerage account instead. In that scenario, the original cost basis of the shares would be taxed as ordinary income upon transfer. Still, any Net Unrealized Appreciation (NUA) could continue to be deferred until the shares are sold. Upon sale, the realized appreciation would be subject to a much more favorable long-term capital gains tax rate instead of being taxed as ordinary income (as would be the case if withdrawn from an IRA rollover). Additionally, by moving the appreciated shares outside of your 401k (implicitly decreasing the value of your IRA rollover), you also reduce the expected value of future Required Minimum Distributions (RMD).
Backdoor Roth IRAs
Many affluent investors are ineligible to make Roth IRA contributions because their Adjusted Gross Income (AGI) exceeds the limits set by the IRS. Several years ago, creative tax advisors spotted a loophole in this rule, which came to be known as the “Backdoor Roth IRA.” This method involves first making a non-deductible contribution to a regular IRA and subsequently converting this amount (tax-free) into a Roth. One hitch: this loophole pre-supposes that the account holder has no other significant IRA assets (if they do, the conversion is no longer tax-free).
The “Backdoor Roth” loophole is likely to close in the near future . Still, while it persists, those who can benefit from it would need to limit the size of their IRA rollover accounts—which means either leaving an old 401k at the former employer or transferring it to their current employer’s plan. Practically speaking, the broadening adoption of Roth 401k accounts (which have much higher annual contribution limits than IRAs, anyway) limits the utility of the Backdoor Roth option.
Estate Planning Considerations
401k plans generally require that an account holder’s spouse be named as primary beneficiary (and that the spouse signs off to approve any other beneficiaries). IRA accounts allow for much greater customization of beneficiaries (i.e., grandchildren, adult children, etc.) which some may find advantageous in estate planning.
IRA account holders over age 72 are required to take annual RMDs. However, the IRS allows account holders to satisfy this RMD requirement by making direct donations from their IRA to a qualified charity (called a Qualified Charitable Distribution, or QCD)—in which case the distribution is not counted as taxable income. 401k accounts do not have the option of a QCD, so those who anticipate making charitable gifts in their 70s and beyond would benefit by having more of their retirement assets in an IRA rollover account.
For some people (especially those who change jobs frequently), keeping track of old 401K plans at former employers can become an administrative hassle. Sometimes, this leads to meaningful oversight and rebalancing decisions being neglected and suboptimal investment results. Moreover, while the IRS allows investors to bundle their IRA accounts to calculate their RMD (and take the distribution from a single IRA account), no such option exists for 401ks. Investors should weigh the benefits of maintaining their legacy 401K accounts against the added complexity this brings to managing their portfolio and satisfying their RMD requirements.
As you can see, deciding whether to rollover an old 401k involves multiple variables, many of which are likely to change or evolve over an investor’s planning horizon. A trusted advisor can help decide which issues to prioritize at different stages in life and how to maintain flexibility in the face of changing financial markets, tax, and estate laws.
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