Benefits of Rolling Over Your 401(K) to an IRA
One of the most important decisions to be made when you are retiring or changing jobs is what action to take with your 401(k), 403(b), or any other employer-sponsored retirement plans. There are several options to consider including leaving your account in your current employer’s plan, transferring it to your new employer’s plan, taking a cash distribution, or rolling it into an IRA.
Tax Considerations
Taking a cash distribution is considered ordinary income and will subject the account balance to taxation, possibly putting you in a higher tax bracket. To make matters worse, taking the distribution prior to age 59 ½ will come along with an additional 10% tax penalty.
If you have a relatively small account balance in your work plan and are changing jobs, transferring your account to your new employer’s plan may be the most favorable option of the four. This election will assist you in keeping track of and managing your account balances collectively.
The Rollover IRA
If you are retiring or changing jobs with a larger account balance, a Rollover IRA may be the best choice. If you leave your 401(k) in your current plan, communication from your former employer may be nominal, leaving you feeling uninformed and forgotten.
Additionally, 401(k) plan sponsors may provide education, but not personal investment and financial planning advice. The rollover maintains the tax-deferred status of those assets without penalty, allowing the assets to grow until you choose to take income distributions. A Rollover IRA puts you in full control of your account, allowing you to manage it yourself. If you choose to work with a financial advisor, they will provide you with advice, investment management, and regular communication regarding your IRA.
Investment Options of IRAs
Investment options in 401(k) plans tend to be limited because the employer is attempting to serve the needs of many employees while minimizing their administrative tasks and expenses. Most plans provide a limited selection of mutual funds including equity funds, bond funds, and target-date funds. When your assets are inside of an IRA, it opens you up to a broad universe of investment choices including mutual funds, Exchange Traded Funds (ETFs), individual stocks, bonds, and alternatives. IRAs allow you to buy, sell and rebalance your holdings at any time. 401(k) plans may set a limit on the number of transactions per year that are allowed, which may limit the amount you can trade or rebalance your account.
IRA Rollover Value
When working with a financial advisor, rolling over your IRA may provide additional value in the form of added services. This can include estate planning coordination of beneficiary designations, financial planning, and investment advice to support your overall financial plan.
Standardized IRA Regulations
Employers have a great deal of flexibility in how they can establish the operation and administration of their 401(k) plan, making the differences between plans difficult to understand. If you’ve worked at multiple employers, you may have noticed that the rules varied from one 401(k) to the other. But for IRAs, the Internal Revenue Service (IRS) has implemented standardized regulations. In other words, all IRAs operate under the same rules making everything much easier to understand.
When you take a distribution from a 401(k), the IRS requires that 20% be withheld for federal income tax. With an IRA distribution, you have the ability to choose the percentage of taxes withheld, if any. This allows you to personalize your withdrawal by having an amount withheld that reflects your specific tax situation, which could lead to keeping more assets in the plan that can continue to compound while invested, tax-deferred.
Estate Planning Flexibility of IRA Rollovers
Rollover IRAs generally provide more estate planning flexibility for beneficiaries when you pass away. For your spouse, they can move your IRA directly into theirs without any taxes or penalties. For non-spousal beneficiaries, they can elect either an Inherited IRA, or withdraw the funds in portion or in full. 401(k) plans may restrict beneficiary elections to minimize the employer’s administrative responsibilities and expenses.
Disclosure: A client or prospective financial advisory client leaving an employer typically has four options regarding an existing retirement plan (and may engage in a combination of these options): (i) leave the money in the former employer’s plan, if permitted, (ii) roll over the assets to the new employer’s plan, if one is available and rollovers are permitted, (iii) roll over to an Individual Retirement Account (“IRA”), or (iv) cash out the account value (which could, depending upon the client’s age, result in adverse tax consequences). If the financial advisor recommends that a client roll over their retirement plan assets into an account to be managed by the advisor, such a recommendation creates a conflict of interest if the advisor will earn new (or increase its current) compensation as a result of the rollover. When acting in such capacity, a registered investment advisor, serves as a fiduciary under the Employee Retirement Income Security Act (“ERISA”), or the Internal Revenue Code, or both.
Kevin C. Kingston
Financial Advisor / Managing Director
ChFC®, CLU®