Have you recently retired, or will you soon? If so, then whether or not you should roll your 401k or other retirement plans into an IRA is something you’ll need to think about.
To make the best decision possible, you need to know three things:
What a 401k rollover is
The pros and cons, and
Understand how a 401k rollover could affect you.
Once you know these answers, you can work with your advisor to decide the best route.
Let’s examine the costs and benefits a 401k rollover can bring to your retirement income strategy.
What Is A 401k Rollover?
Before we examine the pros and cons, let’s review what a 401k rollover is and how it works. When you initiate a 401k rollover, you move funds from your 401k into a different tax-advantaged account, like an IRA (traditional or Roth—more on that later).
The crux of a 401k rollover is its distinction from a withdrawal. Instead of removing money for personal use, which could lead to taxes, fees, and penalties, you can transfer the funds into another tax-deferred account, providing more investment freedom and strategic opportunities.
Rolling your 401k into an IRA allows your money to continue to grow tax-deferred and, when used correctly, isn’t a taxable event.
The Pros Of A 401k Rollover
401k rollovers present unique considerations for investors in the twilight of their careers. Implementing this strategy hinges on the value it will bring to your portfolio. Here are some common benefits of 401k rollovers:
Declutter Financial Accounts
Invite Fewer Taxes on Company Stock
The Ability to Leverage both Traditional and Roth IRA Accounts
You Don’t Have to Wait Until Retirement to initiate the process
Let’s dive into more detail about each of these benefits!
1. Declutter Financial Accounts
Rolling over a pre-existing or current 401k into an IRA consolidates your investment accounts, making it simpler to streamline, organize, and manage those accounts. This is especially important and beneficial for those with 401ks from multiple employers.
The truth is that it’s rare to remain at one company for your entire career. According to the Bureau of Labor Statistics, most people change jobs an average of twelve times over their life, potentially leaving you with several retirement accounts scattered around.
Here are some additional reasons consolidating accounts can be strategic.
It’s simpler to manage. Your life and finances are complicated enough without having redundant accounts. Consolidating them will make your money easier to manage long-term.
You have more investment options. Most 401ks have a limited investment menu, whereas IRAs offer a much broader selection. Basically, the entire investment universe is at your disposal in an IRA.
It could reduce your total investment fees. Housing your hard-earned money with previous employers isn’t free. You’re paying for multiple management and administrative fees when you have multiple accounts. By consolidating, you only have to pay one fee instead of several. You could redirect the money you save into maxing out your accounts or investing in other ventures, like a brokerage account, HSA, or other goals.
Your advisor can directly help you manage your IRA. When you move investments into an IRA, you can enlist the help of your advisor to build a portfolio that matches your risk tolerance, time horizon, asset allocation, tax plan, and long-term goals.
2. Invite Fewer Taxes On Company Stock
If you have company stock, there’s a particular benefit you should understand within a 401k rollover.
Typically, when you withdraw funds from your 401k, you must include the entire amount in your taxable income. So, the IRS taxes the distribution at your ordinary income rates, which tend to be the highest.
However, if you have appreciated company stock with embedded capital gains, you may be able to avoid income taxation on the unrealized gain, also called the net unrealized appreciation (NUA).
Implementing this strategy requires you to adhere to each step meticulously. Here’s an overview.
Distribute the company stock directly, without selling it, into a taxable brokerage account. This process is called an in-kind distribution.
Additionally, you must distribute the remaining 401k balance. It doesn’t matter how you distribute the funds (brokerage, IRA, etc.) as long as you don’t leave anything within the 401k account. As we described earlier, a rollover allows you to do this without incurring additional taxes or penalties.
When you implement this strategy, you’ll only have to pay tax on the basis, which typically means the amount you paid for the stock in the first place.
Since you are only taxed on the net unrealized appreciation when you sell the shares, it’s taxed at the preferential capital gain rate.
Remember that this is a niche strategy requiring significant attention to detail. This is an area your trusted financial advisor can walk you through to ensure you don’t miss any details.
3. You Can Leverage Traditional And Roth Accounts
Your 401k balance might be made up of both pre-tax and after-tax contributions. If you do a rollover, you can distribute each type into its respective IRA. Tax-deferred money will go into a Traditional IRA, and your Roth 401k balance will go into a Roth IRA.
A benefit of rolling your Roth 401k into a Roth IRA is avoiding required minimum distributions (RMDs). With a 401k, you must withdraw at least a certain minimum amount each year once you turn 72, and this even applies to your Roth 401k.
But, by rolling it into a Roth IRA, you can avoid that since Roth IRAs are not subject to RMDs.
4. You Don’t Have To Wait Until Retirement
Although 401k rollovers are typically done at retirement or when someone changes jobs, you may be able to do in-service rollovers while you are still employed.
Why would you want to do this? You might benefit from an in-service rollover if:
Your 401k plan has high fees
You don’t have an extensive investment selection
You want your advisor to directly help you manage the account
Keep in mind that there may be specific rules and requirements for implementing this type of rollover, like employment terms or time thresholds, but most plans allow in-service rollovers starting at age 59.5. Check with your plan administrator to see if this is possible, and then talk to your financial advisor to determine if it’s a solid course of action for you.
The Cons Of A 401k Rollover
Now that you know what some of the primary benefits of a 401k rollover are, what are some reasons you may not want to roll your retirement accounts into an IRA?
Limited Access to Early Withdrawals
Fewer Creditor Protections
No Loan Opportunities
Let’s dive into each of these potential cons.
1. Limited Access To Early Withdrawals
While IRAs are more flexible regarding investment options, they aren’t as flexible when discussing early withdrawals.
Remember, to withdraw from retirement accounts without incurring penalties, you must be at least 59.5. This rule applies to the vast majority of retirement accounts. However, many people don’t know that you could withdraw funds even earlier from your 401k.
The Rule of 55 is a special rule that applies to 401ks. It allows you to withdraw from your 401k without penalty if you retire from your employer when you turn 55. But not every plan permits this action, so check and see if yours qualifies.
So if you plan on retiring early, a 401k rollover may not make as much sense, primarily if you will rely on some of that money to fund your lifestyle.
2. Fewer Creditor Protections
IRAs have less creditor protection than 401ks.
401ks and other employer-sponsored retirement plans are covered under the Employee Retirement Income Security Act, also referred to as ERISA. One of ERISA’s many components is protecting covered plans from creditors. With few exceptions, your 401k is protected from creditors, or civil suit claims.
However, ERISA doesn’t cover your IRA. There is some protection for IRAs at the federal level, but it only applies if you file for bankruptcy. Instead, it is up to each individual state to determine what general protections, if any, apply.
3. No Loan Opportunities
While you can take a loan from your 401k, you can’t from an IRA. This point harkens back to the idea of access. IRAs have limited early access (before 59.5), including taking loans.
A loan is distinct from a withdrawal because it isn’t a taxable event. With a loan, you can put the money back into the account. Although the decision to take a loan from your 401k comes with its own advantages and disadvantages, the reality is it’s a popular feature.
IRA accounts don’t offer this perk. To access money from an IRA, you must withdraw it and pay the applicable taxes and penalties.
Is a 401k Rollover Right for You?
The viability of 401k rollovers depends on your circumstances and your retirement goals.
Your retirement timeline, investment goals, portfolio construction, tax needs, etc., all have an impact on whether or not a 401k rollover is right for you. If you have a holistic view of your retirement plan and goals, you can make more lucrative, strategic decisions.
If you need help understanding how a 401k rollover impacts you, your financial goals, and your retirement lifestyle, we’d be glad to discuss it with you. Set up a time to talk more here!
