Millions of Americans who retire each year are faced with several major financial changes and decisions. One of the key issues that many workers face is what to do with the money that they have accumulated in their 401(k) plans during their working years. Of course, the most common advice that retirees with 401(k) money receive is to roll the plan over into an individual retirement account (IRA). But is this really always the best option? Although the answer to this is clearly yes in many cases, this article will examine the pros and cons of this common financial transaction, and when it may make sense to avoid it. (For more, check out Know The Rules For Roth 401(k) Rollovers.)
TUTORIAL: Retirement Plans
What Are My Options?
There are essentially four options that those with 401(k) money can choose from when they stop working:
1. Roll the money over into a self-directed IRA.
2. Roll the money into the next employer's 401(k) plan.
3. Take a lump-sum distribution of the money.
4. Leave the money in the plan.
The Rollover Option
The first option is by far the most common for several reasons. Rolling the plan into an IRA gives the owner the ability to choose from a much wider array of investments. IRAs allow virtually any type of investment to be placed in them with a small handful of exceptions. Stocks, bonds, certificate of deposits (CD), mutual funds, real estate investment trusts (REIT), annuities and derivatives and even some alternative investments like oil and gas leases can be purchased inside these accounts in most instances. The investment options in many 401(k) plans are fairly limited, and may not be particularly competitive with what's available elsewhere. Some plans (such as the governmental Thrift Savings Plan) have only half a dozen funds to choose from, and some companies strongly encourage participants to invest heavily in company stock. Many 401(k) plans are also funded with variable annuity contracts that provide a layer of insurance protection for the assets in the plan at a cost to the participants that often runs as much as 3% per year. (For more information on the use of variable annuities inside retirement plans, read Getting The Whole Story On Variable Annuities.)
IRAs offer freedom from many of these restrictions, and also usually provide heirs with more flexible payout options than qualified plans. Some plans prohibit former participants from taking a partial distribution of the plan and require that nothing be withdrawn or that the plan be liquidated entirely. IRAs allow owners to withdraw any amount at any time. Of course, brokerage and investment firms compete fiercely for rollover assets, and some firms will pay new customers hundreds of dollars in order to land their business. The increased protection from creditors that IRAs now have also make them more attractive, although there is a $1 million limit on the amount of IRA money that is exempt from creditors. IRAs also allow investors to consolidate all of their retirement funds in just one or two accounts and thereby provides simplicity and convenience. Furthermore, workers can now roll their 401(k)s directly into a Roth IRA if they so choose, which allows them to avoid taking Required Minimum Distributions (RMDs) when they reach age 70.5.
Let It Lie
Despite the restrictions that come with staying in a 401(k) plan, there can be some advantages to keeping your money there for at least a while after you retire. The 401(k) plans that offer loans can give you a means of accessing your retirement assets on a temporary basis without taxation or penalties. Of course, any amount that is not repaid is treated as a taxable distribution, so think carefully before doing this. Another factor to consider is investment performance. If your 401(k) plan portfolio has substantially outperformed the markets over time, then you may want to think twice before rolling your plan over. Most plan administrators will not permit a rollover in-kind, but require the liquidation of all investments within the plan before moving the money. Of course, if you are able to recreate your plan portfolio with reasonable accuracy within your IRA after you roll it over, then this may not be a deterrent. However, this is not always possible, as some plans such as those that use sophisticated investment platforms offered by money management firms may not be available in an independent IRA. A 401(k) and other qualified plan assets are also virtually exempt from all creditors without limit. Therefore, a retired executive with $3 million in a qualified plan who is forced to declare bankruptcy would be foolish to touch this money, because it cannot be attached by anyone (except the IRS). (To learn more, see The 4-1-1 On 401(k)s.)
Those who are moving from one company to another now have the option of rolling their previous retirement plan into the one offered by their new employer, but this may not always be wise either. The investment choices in the new plan should be carefully evaluated before doing this, because the participant may be able to find more competitive choices in an IRA. However, this option can allow the participant to maintain just one retirement account.
Cashing out of your 401(k) plan altogether is seldom recommended, and should probably only be done if you absolutely have to have the money for some reason, such as to pay a large medical bill. Of your plan assets, 20% will automatically be withheld, and the entire balance will be taxed as ordinary income at once, which could result in a substantial and unnecessary tax bill for you, especially if your distribution is large enough to land you in a higher tax bracket.
The Bottom Line
Although it often makes sense to roll your 401(k) money into a traditional or Roth IRA, this is not always the best option. Be sure to find out about your plan's distribution rules before taking action and know what your options are beforehand so that you have time to plan ahead. For more information on 401(k) plan rollovers, download Publication 575 from the IRS website or consult your plan custodian or financial advisor. (To help your 401(k), read How To Get The Most Out Of A 401(k) Program.)