So, you’re at a point where you’ve decided to either change jobs or retire. Whatever the circumstances behind this shift may be, you’re about to enter a new and exciting phase of your life. As you go through this transition, you may be experiencing a lot of change - some good, some bad. However, in the midst of the ups and downs that change brings, you still need to focus on one thing:
What to do with your 401(k) account from your previous employer.
Typically, people select one of two options:
- Leave your money in your existing 401(k) plan.
- Rollover your money into an Individual Retirement Account (IRA).
Obviously, the easiest thing to do is leave your money in your existing 401(k). However, if your account has a balance of less than $5,000 - you may not be allowed to keep money in your existing account.
Besides, keeping your money in your 401(k) may not be your best option!
A 401(k) May Limit Your Investment Options
If you choose to keep money in your existing 401(k), your investment options may be limited. That’s because a 401(k) only offers specific investment choices to their plan holders. The investment choices you’re given are selected by the plan trustees and can be changed or replaced at any time - without your consent. In short - your 401(k) might be limiting your investment options and your control over those options.
The average number of 401(k) plan investment options is around 22 when you consider the entire suite of target-date funds as one. This particular limitation isn’t a big deal if your plan has good investment choices. But, if you take a closer look and find your 401(k) options lacking, it might be smart to do a little more digging to see if an IRA is right for you.
It’s worth mentioning that many people ultimately end up rolling over their 401(k) to an IRA specifically to have more investment options.
If you’re simply transferring jobs, not retiring altogether, I’d consider looking at your new employer’s 401(k) plan, as well. They may have better options than your existing plan does, or that an IRA could provide you with. Also, make sure you check the new company’s plan to make sure you can roll your 401(k) into it before you make any final decisions.
It goes without saying that there is a cost to both a 401(k) and an IRA. There are many articles out there that try to simplify these costs into a few key “takeaway” bullet points - but it really can’t be done. The costs of each account vary widely, and it’s important to do your research before committing to either one.
A good starting place is to check the fees associated with your 401(k). Many 401(k) plans already offer phenomenal low-cost investment options. However, there are a few costs you should look out for. For example, all 401(k) funds that you can choose to invest in have expense ratios. These expenses vary widely from fund to fund.
If you do choose to roll over your 401(k) to an IRA, you should ask the advisor who is helping you to create a list of costs, fees, and benefits so that you can do a side-by-side comparison.
It’s important to note that the advisor who helps you complete the roll over may make a commission off of your IRA roll over. That doesn’t necessarily mean it’s not in your best interest, but it certainly presents a conflict.
To help avoid this, I’d suggest speaking with a fee-only CFP® to make sure you’re making the right decision. A fee-only CFP® who acts as a fiduciary has a duty to do only what is in their client’s best interest - meaning you won’t get sold a product that isn’t the best available option for you.
Services Should Be Considered, Too
Cost shouldn’t be the only thing you’re thinking about when considering making the switch from 401(k) to IRA. The services provided are also important to consider.
Different investment firms (and the financial advisors at those firms) offer different levels of service - and some are better than others. Make sure to set your expectations after doing some research on the different providers you’re looking at. For example, you wouldn’t expect Ritz Carlton level service from a Motel 6. Knowing what you’re in for is half the battle.
The 401(k) plan through your employer may offer some guidance with their on-staff financial professionals, but it’s fairly limited. You’ll likely only be discussing the mechanics of your account, and it’s even more likely that you won’t get the same person twice when you call for assistance.
A CFP® can help you dig a little deeper when determining what to do with your 401(k) and other investment accounts. Their financial planning is more comprehensive, which can be useful when determining how to manage your investments. Moreover, comprehensive financial planning can help you not only save for retirement, but determine the appropriate way to budget during retirement, how to ensure you’ll have an adequate retirement savings for the entire length of your life, and create an action plan to help you achieve short and long term goals.
CFP®s also help you to track down and consolidate any investment accounts that have gone untouched - like additional 401(k) plans from former employers. This will help you keep everything in one place, where your investments can be regularly rebalanced and their performance is continually tracked. Yes, some people choose to do this on their own. But the convenience of having a certified professional help you simplify your finances is worth considering.
If you’re nearing retirement (or even just thinking about it on the distant horizon), you’ll need to take distributions into consideration as part of your rollover decision process. As complicated as a withdrawal savings strategy can be, this step is actually fairly straightforward.
If you’re going to need to take a distribution between ages 55-59 ½, keeping the funds in your 401(k) might be best.
This is because you’re not subject to the 10% early withdrawal penalty with your existing 401(k), whereas you would be with an IRA.
The key to remember is this doesn’t mean you can leave your employer at 54 and expect to avoid the 10% early withdrawal penalty by waiting until age 55 - the rule is defined by the age at which you separate from your employer, not the age you start taking distributions.
In both scenarios, your withdrawal will still be subject to ordinary income taxes. We’re strictly talking about the tax penalty. IRA owners still have 72(t) withdrawals as an option available to them.
If you don’t need to take a distribution until after age 59 ½, this isn’t a consideration you need to worry about.
If you have a 457 plan (like KPERS) as a government worker, you need to know that the early withdrawal penalty doesn’t apply to you.
This plan, that works similarly to a 401(k), is exempt from the early withdrawal penalty, meaning you can access your funds at any age if needed.
Required Minimum Distributions (RMDs)
If you’re currently over age 70 ½, or are planning to work past that age, you’ll likely be able to delay any RMDs from an employer-sponsored plan because you still work there. However, if you don’t work there anymore you may find that RMDs are required.
One of the benefits of rolling your funds over into an IRA is you can utilize a Roth conversion tax saving strategy. To do this, you convert a portion of your IRA to a Roth IRA. Roth 401(k)s are subject to RMD requirements, but moving your funds to a Roth IRA helps you eliminate the RMD requirements and pull funds when you’re ready. This flexibility is especially important during retirement planning.
401(k) plans are typically given extensive anti-alienation creditor protection both inside and outside of bankruptcy. This includes any civil judgement cases (excluding divorce). While IRAs are also afforded anti-alienation creditor protection, your funds are only protected when it comes to bankruptcy - not necessarily from civil judgements and creditors outside of bankruptcy. This law varies from state-to-state, so it’s important to consult an attorney to get accurate information.
For example, I live in Kansas, and many of my clients are local. Kansas state law offers the same creditor protection as federal law, making this a moot point. However, if you’re not a Kansas resident, it’s worth looking into.
Special Rules for Employer Stock
It is incredibly common for a piece of your company 401(k) plan to be comprised of employer stock. If yours doesn’t, you can skip this section altogether!
However, if your plan has any amount of employer stock in it, you’ll need to look at the stock’s appreciation. If the stock has risen in value from when you originally invested, you may be able to set yourself up with some advantageous tax strategies. NUA (or Net Unrealized Appreciation) will allow you to trade ordinary income tax rates for more favorable, long-term capital gains rates.
The downside to this strategy is that you can’t roll your money over to an IRA - or your tax benefits will be lost.
A word to the wise: don’t try and do this alone. Speak with a fee-only, fiduciary financial planner and tax professional who can help walk you through the process (and successfully save money on your taxes!).
⚠️ Whatever You Do - Don’t Do This
Although it may seem like you have endless options - there is one that you absolutely shouldn’t do:
Don’t withdraw the money from your employer 401(k)!
If you withdraw the funds from your 401(k) before age 55, you’ll have to pay a 10% penalty. If you withdraw after age 55, you avoid the early withdrawal penalty, but still would have to pay income taxes on the funds you withdrew. That’s not a good strategy - especially when it comes to your taxes! Even if you need the money, tapping your retirement fund should be a last resort.
Which Option is Right For You?
If you feel like your head’s spinning after reading through the pros and cons of different retirement accounts, you’re not alone. This stuff is complicated!
Both a 401(k) and an IRA are excellent options for retirement accounts. I wish it was possible for me to definitively say one was better than the other - but the truth is, every financial situation is uniquely different. That means that different accounts will fit different people’s financial situation better.
This is why it’s critical to speak with a fee-only, fiduciary CFP® who can help walk you through your options and make the best decision for you. They’ll help demystify the process and empower you to start living your best financial life.
Sound like something you’d be interested in? Contact me today! I’d love to set up a meeting.
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Desmond Henry is a fee-only CERTIFIED FINANCIAL PLANNER™ professional and founder of Afflora Financial Life Planning in Topeka, Kansas. He helps the retiring/retired plan their finances and invest their money. CLICK HERE to learn more.