During my working years, I invested regularly into my 401(k). I chose to use my 401(k) to take advantage of the considerable tax benefits available to an early retiree. This consistent saving, combined with an incredible bull market over the last decade of my career, left me with a substantial balance in my 401(k) when I left in December.
One of the first things that I did upon leaving was figure out what to do with these investments. When leaving an employer, you can leave your investments in your 401(k) or you have the option to roll over the funds to an IRA with the brokerage firm of your choice.
The overwhelming majority of money pouring into IRA accounts is from rollovers from employer-sponsored retirement plans. This is an area of intense competition among brokerages that desperately want this money under their control, allowing them to charge asset based management fees. I strongly recommend reading the FINRA Investor Alerts on this topic to help make an informed decision before rolling over any money.
Either decision could be the correct choice for you. I will walk you through my decision process and share five key factors that can be important when you make this decision for yourself.
For simplicity, I will use the terminology 401(k) throughout this article, but most aspects of this decision making process would apply to any work-sponsored retirement accounts including a 403(b), SIMPLE IRA, etc. There is one exception to this rule that will be explained.
1. Considering Fees
The first thing that I looked at were the fees on my 401(k). I then compared them to the fees I would be paying if I transferred the accounts to an IRA.
It is vital to be meticulous when assessing all of the fees before making a decision. Fees can be difficult to decipher, buried in the mountains of prospectuses and disclosures that accompany most mutual funds and retirement plans.
My 401(k) was allocated between three funds. The funds were distributed as follows:
- 73% was in the Vanguard 500 Index Fund (VFIAX). Its expense ratio is .04%.
- 9.5% was allocated to the Vanguard Small Cap Index Fund (VSMAX). Its expense ratio is .06%.
- 17.5 % was in The Federated Total Return Bond Fund (FTRKX). Its expense ratio is .48%.
My aggregate expense ratio was .12%. This means that for every $100,000 in my portfolio, my annual fees would be $120. If the fees stopped there, I would consider this reasonable.
However, the fees didn’t stop. The entire 401(k) portfolio was subject to an additional .48% annual fee levied by the plan to cover administrative fees. This amounts to an additional $480 in annual fees for every $100,000 invested.
Considering the sum of the fees, my total expense ratio was .60% or $600 for every $100,000 invested. Compare this to the annual expenses of my portfolio invested at Vanguard, which has a cumulative expense ratio around .1%, or $100 for every $100,000 invested.
These seemingly small percentage differences make a massive difference on a sizable portfolio. The rollover option thus saves me thousands of dollars each year, which compounds over time.
2. Investment Options
One potential problem with 401(k) plans is that your investment options are limited to the choices provided by the plan. On the flip side, some large company and government plans can use the economy of scale to provide superior investments than retail investors can get on their own.
One example of the latter would include plans that offer ultra-low cost Vanguard Institutional Shares. Another would be the Thrift Savings Plan offered to many government employees. It is important to fully understand your options.
The investment options offered in my 401(k) were not ideal fits for my portfolio. I used the VFINX as a proxy for my preferred core US equity fund, VTSAX. These funds carry the same expense ratio, and returns are highly correlated. I was happy with this option, realizing that it is a coin flip which fund will perform better over any period of time.
The Vanguard Small Cap Index served as a proxy to my preferred fund, the Vanguard Small Cap Value Index (VSIAX). I prefer to hold the small cap value fund, given its superior historical returns. Fund expenses were essentially the same.
I was eager to switch the bond portion of my portfolio. Federated Total Return Bond Fund served as a proxy for my preferred core bond fund, the Vanguard Total Bond Market Index Fund (VBTLX). The Vanguard fund is composed primarily of US government bonds with some high grade corporate bonds. The Federated option consisted of lower quality, higher risk bonds that do not meet the purpose of bonds in my portfolio as well. The Federated option (expense ratio = .48%) cost nearly 10 times the Vanguard fund ( expense ratio = .05%).
The limited investment options at higher costs than what I had available on my own was a second factor pushing me towards rolling over my 401(k) to an IRA.
3. Benefits and Risks of Aggregating Accounts
One of the biggest positives of doing a 401(k) rollover is the ability to consolidate accounts. I crave simplicity in my finances and appreciate the ability to have all my investments in one place. This decreases the number of funds I hold, allows me to more easily visualize the big picture, and makes performing maintenance tasks such as rebalancing easier.
There are other benefits to aggregating your accounts. For example, Vanguard offers greater levels of benefits to clients with higher account balances. Most brokerages have similar features to attract additional investments under their management.
However, aggregating your accounts under one roof comes with potential downside. Having all or most of your investments in one place can put us at increased risk in a digital world. Threats range from hackers to computer glitches.
I personally put more value on increased simplicity over the potential risks associated with aggregating investments. However, it is difficult to quantify these benefits and risks, so how this affects your decision will largely come down to personal preference and opinion.
4. Age Related Benefits to a 401(k)
Some rules regulating work-sponsored retirement accounts are different than those that govern IRAs. One key difference is that you can begin withdrawals from a 401(k) at age 55 without penalty. IRA distributions can not begin until age 59 ½. Early withdrawals from either type of tax-deferred retirement account are subject to a 10% penalty, in addition to being taxed at regular income tax rates.
In my case, I am only 41 and have substantial taxable investments to bridge the gap to traditional retirement age. I expect to have some ongoing income in retirement. In addition, I anticipate having some years with very low income, allowing me to utilize Roth IRA conversions, providing access to a portion of this money prior to traditional retirement age.
These factors made the age related benefit of the 401(k) of minimal importance in my decision. However, this can be a substantial reason to not roll over a 401(k) for some people.
5. Asset Protection
Another distinct advantage of not rolling over a 401(k) account to an IRA is superior protection of your assets from lawsuits. 401(k) plans (as well as deferred compensation plans and profit sharing plans) are ERISA qualified retirement plans.
Traditional IRA, Roth IRA, and some work sponsored plans including including some SIMPLE IRA and 403(b) accounts are non-ERISA qualified retirement plans. Non-ERISA qualified plans are protected by state laws which vary widely.
Bankruptcy laws also differentiate between the types of retirement accounts. All retirement accounts are given some protection against seizure in bankruptcy proceedings. However, non-ERISA qualified plans have exemptions above certain amounts that ERISA qualified plans do not.
There are some asset protection benefits to staying in a work sponsored retirement plan, particularly if it is an ERISA qualified plan. They are beyond my scope of expertise. If asset protection from lawsuits or bankruptcy is a significant concern, then you should consult with a qualified attorney to get more detail on these topics as they apply to your personal situation. I am not an attorney and don’t want to play one on the internet.
Financial Aid For Your Student
Given the different legal treatment of different types of retirement accounts, I was curious if there was a similar corollary with the way different types of retirement accounts are considered when applying for financial aid for college.
I reached out to Brad Baldridge of Taming the High Cost of College to ask this question. He summarized the process very succinctly.
When applying for college aid, there are assets that count against the amount of aid your child can receive. They include bank accounts, taxable investments, and 529 accounts.
There are other assets that do not factor into the amount of aid your child can receive. Assets held in retirement accounts fall into this second category. They do not factor into financial aid calculations.
Therefore, there is benefit to utilizing retirement accounts over taxable accounts with regards to student aid you are eligible to receive. However, all retirement accounts are treated the same for aid purposes, so this does not need to be factored into your rollover decision.
When I considered my decision, a few factors clearly stood out above the others. Being able to substantially reduce my costs, align my investments more closely with my objectives, and simplify my portfolio led me to choose rolling over my 401(k) to an IRA.
The one thing that gave me pause was the superior asset protection offered by keeping my money in a 401(k). However, when I looked at things objectively, the guaranteed benefits of rolling over my investments to an IRA outweighed the potential benefits of staying in my 401(k).
Hopefully, this analysis will give you a framework for making the best decision when applied to your individual situation. There is no one size fits all answer to whether you should stay in your 401(k) or elect to roll it over to an IRA when retiring or changing jobs.
[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at firstname.lastname@example.org.]
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