Did you change jobs recently? Or, perhaps, are you in the middle of a search that may lead to a new employer this year?
Whatever the circumstance, you’re likely to be facing a laundry list of must do’s. And not just big things like finding your feet in your new job – but also a likely deluge of administrative tasks like sorting out your new benefits package, updating your contacts, and the like.
But take our advice: don’t forget your 401k rollover decision! Let’s start with your options:
- Leave your money with your old employer’s 401k plan
- Roll your assets over to an individual retirement account (IRA)
- Cash out your money (take a lump-sum distribution and pay the tax plus a 10% penalty if you’re younger than 59.5)
- Cash out a portion (and pay the appropriate taxes and penalties) and roll over a portion
For most, the decision is clear: move your assets into a rollover IRA. In the following post, we’ll discuss why that’s the case. (At a high level, it’s because you typically have lower fees, a greater selection of investment options and increased withdrawal flexibility.). However, there are specific scenarios (such as owning stock in your company in your 401k) where at least a partial cash-out makes sense. In almost no cases do you want to leave the funds in your old portfolio.
IRA Rollovers: Why They’re a No-brainer
New data show that 45% of investors receiving a lump-sum through 2012 moved the entire amount of their savings to a tax-qualified account like an IRA, according to the Employee Benefits Research Institute (EBRI). That’s a significant jump from 1993 when 19% did so. It’s an encouraging trend.
For all the benefits that come with 401ks (which we’ve written about in Unlock Your Retirement Savings Potential: The 401k), they’re also limiting in several key ways. What’s more, the employer match ceases with employment – which means the 401k’s chief benefit desists as well. Read on to figure out why Rollover IRAs compare favorably to old 401ks.
The Cost Factor: Lower Fees
401ks are costlier than IRAs, mostly because they come with an extra layer (or layers) of fees. First, there are administrative fees. These are in place to cover the “day-to-day operations” of a 401k, including recordkeeping, accounting, legal and trustee services. Then, there may be management fees, including advisory fees like a 3(38) fee – which kicks in if your employer elects to pay to a third party firm for taking on the fiduciary responsibility of managing your 401k plan. In addition, investment options tend to be more expensive.
All in, expensive 401k plans have the potential to carry a 1% fee premium – even relative to other 401ks. As reported by the Government Accountability Office, small plans are disproportionately expensive. Participants in plans with under $10 million in assets pay 1.9% in fees on average, compared to participants in plans with over $100 million in assets, who pay on average 1.1%.
Let’s take a look at a simplified example to see how a 1% fee shift impacts your retirement assets. Say you’re 40 years old with an old 401(k) from a prior job with $150,000 in assets. That plan charges 1.5% a year in annual expenses. Fast forward 30 years: the account is now worth more than $560,000 (assuming a 6% growth rate and a 1.5% fee).
With a fee that is 1% lower – 0.5%, the value of your portfolio would be a staggering 33% greater in 30 years. If your $150,000 is invested in funds with a 0.50% fee, your net annualized gain is 5.5%. That will turn today’s $150,000 into nearly $750,000 within 30 years. By lowering investing costs you could boost your retirement savings by nearly $200,000 – and you didn’t assume additional risk.
IRA’s don’t come with any of these plan fees, which is a great reason to think about a rollover. If you don’t know what fees are in your 401k, Personal Capital’s free 401k Fee Analyzer will tell you that whether a rollover does in fact give you a fee advantage.
Investment Options: More Choices
The second reason to think about an IRA rollover is to improve your investment selection. Once the money settles into your IRA, you or your advisor can choose among thousands of ETFs, bonds, mutual funds or individual stocks. You’re no longer limited to the dozen or so mutual funds typically offered in a 401k.
As we’ve written in the piece, Guaranteed Failure With Mutual Funds, mutual funds are not only expensive but tend to underperform the market. ETFs, on the other hand, provide are great, low-cost, tax-efficient way to track the markets and create a well-diversified portfolio. Low-cost investments help boost your retirement security – without having to ramp up savings or portfolio risk.
Your investment time horizon and risk tolerance, along with several other factors, will ultimately guide your asset class decisions. You can use the Personal Capital Investment Checkup Tool to help determine your target allocation and see how your existing portfolio compares.
Finally, as in any retirement account, when you make trades within your IRA account, you can do so without generating IRS reporting requirements. Think of it this way: when you unload shares you’re not taking a distribution, and you’re not making a contribution when you use the profits to re-invest. With more flexibility in your investments, this benefit is more pronounced in IRAs.
Early Withdrawal Flexibility: the 72(t) Distribution
IRA investors mulling early retirement should be aware of IRS Rule 72(t), which allows for penalty-free IRA withdrawals before age 59 ½. Once you pull the trigger on a 72(t) distribution, you must continue to withdraw substantially equal periodic payments for five years, or until you turn 59.5 – whichever is longer.
This method, however, has several rules and should not be entered into lightly. Some of those rules center on how distributions are taken and exactly how much may be withdrawn – an amount determined by the IRS.
When Cashing Out Makes the Most Sense: Your 401k is in Company Stock
Sometimes you may have a pressing need to cash out your 401k when you leave your employer that might merit the penalty, if you’re younger the 59.5 years old. For instance, if you’re in debt and your borrowing costs are high. But even if you’re not in need of the funds right away, there is a special case in which cashing out a portion makes sense – and that’s if your 401k has a portion invested in company stock.
The reason? Company stock has different tax treatment if it’s taken out as a lump sum distribution from a 401k. Typically, whether you withdraw money from a 401k as a lump sum distribution or regularly during retirement, you pay tax on all of your withdrawals at ordinary income rates. Gains that came from appreciation of your portfolio and income therefore have the same tax treatment.
With company stock, on the other hand, if you take a lump sum distribution from a 401k, you’ll only be taxed at ordinary income rates on the cost basis of your company stock investment. Any growth in your company stock is considered “net unrealized appreciation,” (abbreviate NUA and calculated as the difference between the value of the stock at the time it was put into your 401k and the time of distribution). You’ll only pay tax on your NUA once you sell that stock, and if you sell it a year after taking the lump sum distribution, you’ll be taxed at long-term capital gains rates. It’s definitely helpful to consult an advisor or tax professional who understands NUAs to optimize your tax decision.
Except in the case that you own company stock in your 401k or need access to your funds immediately (and for some reason the 72(t) doesn’t make sense for you), it’s typically best practice to convert your 401k to a rollover IRA. Once you’ve made the decision to rollover, the process is not complicated, but there are factors to keep in mind.
The first is to make sure you do a “direct rollover.” This means the money is moved directly from your old 401(k) to the new brokerage account or fund family. It’s important because if you fail to do a direct rollover, you could be hit with an unwanted tax bill. But don’t let this hinder you: your new financial institution of choice should be able to give you step by step guidance to complete this process hassle-free.
From there, the world is your oyster! Not only do you have likely lower fees, more investment options, and potential early access to your funds, but you can also continue to contribute. All of these factors make the rollover IRA a great retirement account decision.