Should You Rollover Your 401(k) to an IRA?
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 a bull market over the last decade of my career, left me with a substantial balance in my 401(k) when I left my job.
One of the first things that I did upon leaving was figure out what to do with these investments. Is it better to leave them in the 401(k) or roll them into an individual retirement account (IRA)?
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. I’ll explain the one exception to this rule.
Why Should I Be Careful When Rolling Over My 401(k)?
According to the Center for Retirement Research at Boston College, the overwhelming majority of money pouring into IRA accounts is from rollovers from employer-sponsored retirement plans. They report that only 13% of new money flowing into IRAs annually is from individuals’ contributions.
Brokerages compete intensely for this money being rolled over from employer sponsored plans to IRAs. They desperately want these dollars under their control, allowing them to charge asset based management fees.
The Financial Industry Regulatory Authority (FINRA) issued an Investor Alert on this topic to help consumers make an informed decision before rolling over any money.
When can I roll my 401(k) into an IRA?
When leaving an employer, either to switch jobs or retire, you can leave your investments in your 401(k). Alternatively, you have the option to roll over the funds to an IRA with the brokerage firm of your choice.
There is no time limit to initiate the rollover. There are various ways to transfer money from your 401(k) to your IRA.
If the funds are distributed directly to you, there is a 60 day time window to deposit the funds into an IRA. You can find the complete IRS rules governing Rollovers of Retirement Plan and IRA Distributions here.
Some retirement plans allow in-service rollovers, rolling over your work sponsored retirement account while you are still employed at the company.
Not all plans allow in-service rollovers. Those that do often have restrictions related to your age or other factors like the length of time you’ve contributed to the plan. Check your individual plan documents if you are interested in an in-service rollover.
Should I Rollover My 401(k) to an IRA?
The 5 key factors to determine whether you should roll your employer sponsored retirement plan to an IRA are:
- Investment fees,
- Investment options,
- Benefits and risks of aggregating accounts,
- Different age related benefits and restrictions of different account types,
- Asset Protection.
Either leaving your money in your 401(k) or rolling it over to an IRA could be the correct choice for you. I will walk you through my decision process to help you make the best decision for yourself.
What are the advantages of rolling over a 401(k) to an IRA?
The biggest advantages of rolling over a 401(k) to an IRA are:
- The opportunity to slash investment fees,
- More control over your investment options, and
- The ability to simplify your portfolio by aggregating accounts.
Cutting Investment 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.
I allocated my 401(k) 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.
Related: Do High 401(k) Fees Outweigh the Benefit of Participating?
Increased Investment 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 and 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.
Benefits and Risks of Aggregating Accounts
Another positive 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.
When you have to take Required Minimum Distributions (RMDs), having your accounts consolidated also makes this easier. If you have multiple retirement accounts, you have to calculate and take separate withdrawals from each. Find IRS rules regarding this situation here.
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.
What are the disadvantages of rolling over a 401(k) to an IRA?
Cutting fees, improving investment options, and simplifying your portfolio are compelling reasons to roll your 401(k) to an IRA. However there are several potential reasons to leave your 401(k) where it is. They include:
- Superior investment options in some 401(k) plans,
- Age related benefits of 401(k) accounts,
- Superior asset protection.
Losing Access to Superior 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 companies 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 example of a plan with great investment options is the Thrift Savings Plan offered to many government employees.
If your work sponsored retirement account offers acceptable investment options, and especially if it offers superior funds than individual investors can purchase, there are compelling benefits to not roll over your account to an IRA.
Age Related Benefits to a 401(k)
Some rules regulating work-sponsored retirement accounts are different from 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 was only 41 when making this decision. I have substantial taxable investments to bridge the gap to traditional retirement age.
I also expect to have some ongoing income in early 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.
Another option that may make sense for some people is rolling over a portion of your 401(k). You can bridge the gap to age 59 ½ with the portion kept in the 401(k). The remainder may be rolled over to improve investment options or lower investment fees.
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 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. A state-by-state analysis of IRAs as exempt property from bankruptcy and debtors can be found here.
The take home message is 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.
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 found that when applying for college aid, there are assets that count against the amount of aid your child can receive. They include taxable bank accounts and investments as well as 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 category. They do not factor into financial aid calculations.
Therefore, there is benefit to utilizing retirement accounts generally over taxable accounts with regards to student aid you are eligible to receive. However, all retirement accounts are treated the same for aid purposes. You don’t have to factor student aid into your rollover decision.
My Final Analysis
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.
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[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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If your IRA is specifically marked as a rollover IRA, you should have the same legal protection you had when it was in an IRA. You would have to be careful to avoid moving the 401K funds into an existing non-rollover IRA.
Do you have a source for that? That’s not my understanding, but that would be important information and I’ll gladly amend the post to reflect it if that’s the case.
A rollover IRA will lose ERISA protection, but will gain BAPCPA protection. BAPCPA protects your rollover IRA assets in the case of bankruptcy, and there are other legal protections depending on the state you live in. This is discussed in the following Investopedia article:
David, thanks for sharing the reference link and information. I was not aware of the details on this. I note, however, that the article only references bankruptcy protection and does not include the broader scope of civil or criminal creditor protections. My understanding is that ERISA provides greater protection for a broader scope of potential legal liablity risks vs. an IRA/BACPA. The courts would throw out any claims of bankruptcy if the timing was suspicious vs. a creditor claim.
One would likely need to consult with an experienced and specialized attorney in state of domicile for a (kind of) definitive answer. But then if you move to another state at any point the legal consequences change. Interested in your opinion if you have anything to add or correct.
One other consideration to throw in the mix could be if, after leaving the job with the 401k, you want the option to do backdoor Roth contributions. If you do want that option, you won’t want any pre-tax IRA balances (indicating, don’t rollover the 401k if it is non-Roth). Otherwise, you’ll be hit with the pro-rata rule and have an associated tax bill.
Exactly the reason Im not moving my wife’s 403b to an IRA…we continue to do backdoor Roth and I didn’t want to mess that up. Glad to see it confirmed here.
Good point! I’ll amend the article to reflect that.
Another option and one I took advantage of when leaving a previous employer is to roll your old 401 to your new employer’s 401 plan. It helped me psychologically because it didn’t seem I was starting a new 401 with a $0 balance.
I suppose I was thinking more from the standpoint of leaving employment, but you make a good point that you can roll the account to your new employers plan, assuming the plan allows it. Not all do.
That’s a great idea for people with a good plan to roll to. I never considered the psychological benefits of not starting at $0 balance, but if it helps and encourages you to see a bigger balance that’s all the more reason.
You should mention that you can withdraw early , without a 10% penalty, using rule 72T.
You could use rule 72T with either type of account. https://www.irs.gov/retirement-plans/substantially-equal-periodic-payments
I suppose if you are only staying in a 401(k) for the reason of accessing your money sooner that could be helpful.
Thanks for pointing that out.
Thanks for this. I recently went through this process, and I made the same decision, primarily driven by the concern with the fees in the 401(k), which really bite once the account is large enough, and the desire for consolidation and ease of management. Age was not a factor for me.
Fees can be the overwhelming factor driving this decision for many. They were for me, and my plan was not nearly as egregious as some I’ve seen. Hopefully that will improve as fiduciary rules are enforced and fees generally drop.
There is another factor in favor of leaving in 401k. If you roll it over to traditional IRA, you can no longer make back door IRA contribution/conversion if your income is over the limit, as the conversion is taxed on a pro rata basis.
Thank you Chris. Your post is a very well-written and thorough analysis.
I would also add that ERISA plans have different legal privileges that allow them to offer some insurance products that IRAs cannot by law. For example, stable value funds offering competitive rates can only be offered via ERISA plans. This was a consideration for me in an environment in which I wanted some protection from rising interest rates for a fixed income / bond slice of my portfolio.
Darrow’s recent article in which he mentioned his accident lawsuit and defending that seemed like a situation any of us who drive a vehicle could find ourselves in with lawyers going after our assets.
Well done Chris, thank you!
Addendum – I would also add Chris that in most 401ks, etc. the investor does NOT have the option to move to a cash position. For those extreme times when things look very dark in the investment world, having an ultra-safe option (e.g., Treasuries or cash) to move my life savings to would give me more comfort vs. the various money market hybrids offered in a 401k. Most 401ks do not offer a cash or treasury-backed option, in my experience.
Interesting point Bill. It’s one I wasn’t aware of. I’ll add it to the post.
When I was helping manage my company’s 401K plan we chose to pay for all the accounting and operational fees associated with employee accounts with company money. The only fees that participants were charged were the expense ratio fees associated with the investments they elected to purchase within their accounts. I believe this is not unusual for corporate plans.
I think it’s not uncommon either way: for the employer to cover or to not cover the admin fees. My employer covers them, my husband’s does not!
My wife has invested in three different employers plans. I had one, the example given in this post. Unfortunately, mine was by far the best of the three with regards to fees.
I agree with Stephanie, but steveark I commend you for doing that and wish more employers were at least more aware of the more egregious fees charged on some plans.
I opted to keep my two 401k’s in tact. I triple checked, and there were no other fees besides those for each individual position – i.e. no administrative fees.
Like a few others, mentioned already – keeping funds in a 401k greatly facilitates Backdoor Roth IRAs. Once you roll a 401k into an IRA, that entire balance becomes subject to the ProRate rule and makes the Backdoor Roth more expensive. A good employer should advise departing employees about this.
I retired & rolled my 401k into an IRA. Now I need help figuring out if I should roll something into a Roth IRA each year to reduce the future hit of required minimum distributions on the IRA. I’m 62, so 10 years to go before RMD. Any articles out there that would be helpful? Thanks
Darrow has written an article on this site about the general framework for thinking about Roth accounts. https://www.caniretireyet.com/roth-iras-roth-conversions-needs/
Mike Piper recently published this more comprehensive step-by-step analysis of Roth conversions: https://obliviousinvestor.com/roth-conversion-planning-a-step-by-step-approach/
It’s important to consider this decision in the context of your situation and how it will impact not only direct income taxes but also ACA subsidies if you’re buying health insurance through the marketplace and later Medicare premiums. Both the Pralana and NewRetirement retirement calculators we affiliate with help you with this analysis.
Hope that helps,
The backdoor Roth is an issue, in the off chance that you are still working and squirrelling money away.
I think you understated the creditor protection piece. I’m not sure about the demographics of your readers, but if they have a 401k + PS + CBP, a long career will lead to much more to protect than the 500k offered by my state. It would take a heck of a lot of fees to make me willingly give up that!
Two counterpoints to your argument.
1.) I agree with you in theory, but understand a lot of these plans do have a LOT of fees. My plan would cost me at least $100k over the 30 years to age 70 with conservative growth assumptions. Others are much worse.
2.) A lawsuit could be destructive, but is highly unlikely. Fees are guaranteed.
Chris a counterpoint to #2 – Although statistically unlikely, A lawsuit that does not go your way has very asymmetrical risks, as i see it. You lose and your life savings potentially gets wiped out. Akin to fire or earthquake insurance, as I see it. But I do agree that it is a personal risk management decision each has to asses for their own circumstances.
Thanks for the reply, Chris. So that is roughly 30 bps on a $1M portfolio. What is the difference you are looking at in the rollover account? If the difference is 25 bps, that would get my attention. But even so 3k/yr for simple, ironclad protection sounds cheap to me!
I find that concern over liability is dynamic through life…you may feel differently when your daughter starts driving!
And I also acknowledge that the far most likely judgment will come from a divorce settlement….
Nice summary. I didn’t know about ERISA so will look into that. Another downside I’ve personally struggled with in moving assets from 403b for my wife to an IRA is we would be losing about 20 years of personal performance data on the investments she has in the account. In Kind transfers aren’t an option for her. I’m tracking in Quicken, but it would basically all reset once I moved the money into a new account, and new funds/etfs. Bummer to lose that long-term history…or more accurately it’s not simple to tack on to that investment performance history to a whole new set of funds…at least that I’ve found.
Another issue Im grappling with is non-deductible IRA contributions then backdoor to a Roth. I’ve been doing this for 10+ years…once I move my wifes 403b assets into an IRA, my understanding is tracking non-deductible IRA contributions gets a bit more complicated. May be a solution here but I haven’t figured it out, so holding off.
RE: tracking performance. I know I’m in the minority here, but I don’t track performance. So that would be a non-issue for me.
A number of other readers also pointed out the backdoor consideration, which is one I neglected. I plan to amend the post to address that. Hopefully I’ll get to it today.
While you mention 403(b) plans, you fail to mention that ministers can withdraw from a 403(b) plan an IRS-approved “housing allowance” that is not subject to Federal or State income tax. When one rolls over any funds from a 403(b) to an IRA or other investment product, one loses that benefit on those funds.
There are too many IRS allowances and rules like this to list them all, but it is an excellent point that each individual should check to see if there is anything that applies to their specific situation.
One other big advantage of IRA’s over 401Ks is that if you’re fortunate enough to be able to make significant charitable donations, after age 70 1/2 you can do this via direct transfer from an IRA (but not 401K). Transferring directly avoids having to count the distribution from the IRA as taxable income.
Hmm, there are so many pluses and minuses. But no doubt, due to the fact that the history of your accruals from 403b is disappearing, this is not yet suitable for me. But in general I am thinking about the transition to the IRA.
Nothing lasts forever. 🙂 I had a sizeable chunk of my retirement money in a former employer’s 401k for about 20 years. They were smart about the management and paid the fees like mentioned above. About 5 years ago, my former employer was purchased by a large multinational who will remain nameless. The 401k remained unchanged. Still managed locally by smart people who paid the fees. This last year, the multinational took it over.
They lacked logistical competence. (They couldn’t even see that I had money in the 401k)
They were unwilling or unable to give me prospectuses for the in-house funds they were transferring my money to.
I transferred the money out to a rollover IRA pretty quickly.
Can you rollover a portion of the, in my case, 457 account? Leaving what I need for pre 59.5 use, and roll the rest into lower fee Trad. IRA
One of the biggest reasons to move from a 401K to an IRA that you didn’t mention is that many “past employer” 401K plan do not allow you to withdraw part of the 401K. It’s an all or nothing withdrawal. This is not very practical for 99.999% of people. You’d prefer to take some money out each month or each year. I’m told a huge percentage of 401K have this rule, but every 401K has it’s own rules and you should check your 401K. Their thinking is they don’t want to manage your payouts. So for many of us, the question isn’t “if we want to rollover”, it’s “when will we rollover”.
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