Should I Roll My 401(k) to an IRA?
Many of us will change jobs multiple times in our careers and if we’ve been contributing to a retirement plan where we work, it’s only natural to wonder what the best options are for managing that account since we won’t be making contributions to it any longer.
If we elect to do nothing, we may accumulate multiple employer-sponsored retirement plans over the years, leaving us with a cumbersome management issue as we approach retirement.
Thankfully, rollovers are a convenient way to manage retirement assets both during and after our working years.
In this post, I’ll discuss when you can and can’t roll over an employer-sponsored retirement account, where you can roll it to, and why you should or shouldn’t do that.
As we walk through this I will primarily comment on 401(k) plans, but rollover rules are basically the same for 403(b)s, 457s, and TSPs also.
When Can You Rollover a 401(k)?
First, if you are still working for the employer who sponsors the retirement plan you want to roll over, then you’ll have to reach out to them for guidance or check out your summary plan description.
Unfortunately, only about 30% of 401(k) plans offer in-service withdrawals, so odds are you won’t be able to roll funds from your plan at work to an IRA until after your employment ends.
Once you’re no longer working you can make a rollover at any time. This includes termination and retirement. We’ll explain why you may or may not want to move the money out of an old 401(k) in a minute.
Where Can You Rollover Your 401(k)?
If you want to roll money out of a 401(k) and into another tax-advantaged retirement account, you basically have two options.
If you are moving from one employer to another, you can typically roll the money from your old plan into the new one. At least, I’ve never heard of a plan that wouldn’t accept a rollover from a previous employer.
The other, and more common, option is to roll your 401(k) into an IRA.
You’ll have to select a plan custodian before navigating some paperwork to move the money to the IRA, but it’s not that challenging to do as it is an everyday occurrence for the companies that operate IRAs.
Why You Should Roll It Over?
There are several good reasons to roll an old 401(k) to an IRA.
1) Access to Better Investments
I’ve completed a few rollovers as I’ve changed jobs several times in my career and the primary motivation each time was control over the assets in the plan.
Only once have I participated in a 401(k) plan that had what I would consider an adequate variety of investment options with reasonable fees.
The fact is the investment companies that operate your company’s 401(k) are in it for the profitability these plans provide.
Since 401(k) plans give them a semi-captive group of investors, there’s not a lot of incentive to keep fees low unless the employer does a good job negotiating this on behalf of their employees.
And, unless there’s a large pool of plan participants, your employer is going to run into resistance negotiating for lower-cost investments because the custodians rely on these fees for their profit.
So, if you’re at a smaller company, odds are the fees that accompany your investment options will be higher than if you were working at a larger company.
However, moving to an IRA allows you to select the plan custodian and the investments you want as opposed to being limited to the small list of options that are available in your 401(k).
It may also be true that the 401(k) plan at your new job is superior to your old plan making a rollover to the new plan a viable option as well.
2) Easier Management
I’m sure you’ve heard of a “broadly diversified portfolio” before.
Portfolio diversification is a critical step for reducing risk and producing steady returns for your investments.
Naturally, the fewer accounts your retirement assets sit in, the easier it is to manage all of your investments as one, single, strategic portfolio.
This is the primary reason many retirees move their old 401(k)s into an IRA upon retirement. It’s just easier to manage this way.
But this is also true if you’ve changed jobs multiple times and have a collection of old 401(k) plans that are either a challenge to keep an eye on or you just don’t bother to check on them at all.
3) Others
There are a few other, less impressive, reasons to roll over to an IRA.
- You’re probably not going to get great service from a plan you’re not contributing to any longer. After you leave your old employer, you’re really just a cost for them since you aren’t adding any new money into the account. They’ll never say it outright, but they might prefer that you just move on.
- Some companies will offer incentives for you to roll your old 401(k) into their IRA, though I wouldn’t let this be your sole consideration for selecting an IRA custodian.
- Heirs have up to 10 years to fully liquidate an IRA. If you leave a 401(k) in your estate, they may be forced by the custodian to take a full distribution at one time. This makes tax planning a but more challenging for your heirs.
- Finally, as I’ve already pointed out, 401(k) plans can have unique rules. The rules for IRAs are much more standardized making them more predictable and easier to understand.
Why You Shouldn’t Roll It Over?
1) Backdoor Roth IRA
The best case I can make for not rolling an old 401(k) into an IRA is because it will probably make the Backdoor Roth IRA strategy much more difficult to execute.
In case you’re a little rusty on the details, the Backdoor Roth IRA is a method people can use to direct money into a Roth IRA, who would otherwise be ineligible because of their income.
By putting after-tax dollars into an IRA and then promptly converting to a Roth, investors can avoid the income restrictions that apply to Roth IRA accounts.
The major hurdle to this strategy is the Pro Rata Rule which requires you to account for all IRA assets on a pro rata or proportional basis when calculating the taxes owed for Roth conversions.
So, if you have a large tax-deferred IRA balance, using the Backdoor plan will probably come with significant taxes.
And there isn’t much that will inflate your IRA quicker than a rollover from a 401(k).
So, if you think you may want to use the Backdoor Roth strategy in the future, a 401(k) rollover may not be in your best interest.
2) Legal Protection
In many states, the legal protections afforded to 401(k) plans are better than those provided for IRAs. This means you could inadvertently make your 401(k) vulnerable to a lawsuit if you roll it into an IRA.
But it depends on the state.
If you have questions about this one you should see an attorney that is familiar with the laws for your state.
Roll It Over Carefully
If you’ve read through this and decided that a rollover is just the thing for you, I have one final word of caution.
If your 401(k) plan administrator sends a check directly to you for your rollover to an IRA, you’ll have 60 days to get those funds into your IRA before it is considered a distribution.
That could be bad for a couple of reasons.
First, any tax-deferred portions of your 401(k) will be subject to income tax. The bigger your 401(k), the bigger the tax.
Another reason this is bad is because if you’re under age 59.5 when you get the check, you’ll owe a 10% penalty for the amount of the distribution.
So, if you’re in the 24% tax bracket and you accidentally take a distribution, you’ll pay 34% of that in taxes and penalties back to Uncle Sam.
If you’d rather not give the government one-third of your 401(k), try to do a direct rollover instead.
In a direct rollover, your 401(k) plan administrator will send a check directly to your IRA custodian, meaning you never receive it, meaning there’s no danger of penalties or taxes.
With all of this said, your 401(k) plan administrator may be a jerk and refuse to send a check to anyone but you. (This may or may not have happened to my wife recently.)
In this case, just be sure you’re very clear giving instructions about how the check should be issued and where it needs to go after you receive it.
Wrap Up
In most cases, rolling your old 401(k) to an IRA is going to make sense. Hopefully, this information will be useful as you navigate this decision yourself.
For more about IRAs and 401(k)s, I recommend checking out our YouTube channel which has playlists covering both of these topics in detail.
