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The Problems With 401(k) Rollovers Part 1

Many people have substantial funds invested in employer-sponsored retirement plans, with one of the most popular tools being a 401(k) plan. Plan contributions, and the earnings on those contributions, avoid income tax until they are withdrawn. And the Employee Retirement Income Security Act (ERISA) and Department of Labor (DOL) rules have so far kept creditors at bay and financial service providers on their best behavior when dealing with company-sponsored retirement plans.

But the growing value of assets held in retirement accounts has attracted the attention of many, and more specifically the government, who would like to finally collect some taxes, and financial service providers who would like to turn institutionally-priced pooled accounts into retail-priced accounts, one rollover at a time.

As one considers what to do with his or her accumulated assets, including whether to roll them over, it is important to understand what choices are available and what impact those choices will have. At retirement, most can choose between keeping their money in a 401(k) account, or rolling it over to an IRA. Taking a lump sum taxable distribution is also an option, but is typically not in the best interest of most people as it brings the tax liability forward and creates a hard to resist temptation to spend.

Financial services firms market heavily for corporate retirement plan rollovers because it is an opportunity to create more profitable individual business relationships with participants. Recent Securities and Exchange Commission (SEC) and DOL comments have identified this as a source of potential conflict of interests between 401(k) providers and their retail affiliates. Comments from regulators have focused on the potential breach of fiduciary responsibility when companies or individuals related to plan providers are poaching soon-to-retire plan participants and that some IRA rollover programs or products are poor alternatives, doing more harm than good. That said, there are attractive alternatives to IRA rollovers, but there are a myriad of things to consider when evaluating this action as well. Some of the items that should be on one’s radar screen are:

Creditor Protection for Retirement Accounts

Assets held in an ERISA-governed retirement plan may have better protection from creditors than those in an IRA. In 2005, Congress overhauled the bankruptcy laws, making practically all retirement accounts and pension plan funds exempt from liquidation in bankruptcy and from your creditors. Although the new federal bankruptcy laws provide broad protection for ERISA-governed retirement and pension plans, there are a few limitations to this protection. While most “rollover IRAs” funded from qualified plan distributions are exempt from bankruptcy, protection for “contributory IRAs” are limited to an inflation adjusted, $1.17 million of protection.

Beyond that limit, state laws vary considerably when it comes to protecting IRA assets and dealing with other kinds of lawsuits. Of note, 401(k) rollover funds that are commingled with contributory IRA funds are generally subject to the rules governing contributory IRAs and creditor protection will follow state law. The amount in your IRA and where you live (or will live) are important factors in determining your IRA’s protection from creditors. (For more, see: Which Retirement Funds Are Protected from Creditors?)

If your retirement assets are protected under federal and/or state law, creditors cannot force you to liquidate your retirement funds to pay your debts. But some debt collectors are notorious for asking debtors to borrow from their retirement funds to pay off debts or other obligations, and many individuals fall into this trap. However, there are instances when your retirement funds can be taken from you, including divorce proceedings and/or tax settlements with the IRS.

Retirement Account Investment Fees

Another important consideration whether your money is in an employer-sponsored 401(k) plan or an IRA are the associated costs for that plan. It is important to understand both the cost and the service associated with those costs. As a rule of thumb, the further one gets away from the people actually managing the securities in a portfolio, the higher the overall cost will typically be.

401(k) Costs: There are four major categories of costs that are incurred by 401(k) programs: investment, recordkeeping, administrative and custody. New regulations instituted in 2012 by the DOL require 401(k) plan sponsors to provide simplified disclosures showing administrative expenses and fees to participants. The fee disclosure notices outline all of the costs a participant pays to participate in the employer’s 401(k) program, so every 401(k) plan participant should know exactly how much their 401(k) plan cost. Generally, the larger the size of the company’s overall 401(k) plan assets, the lower the overall cost should be on a per participant basis. We have seen total costs run between 0.8% to 3% per year, depending on the amount of assets, number of participants, complexity of the program, services offered and of course, the specific provider used.

IRA Costs: There is not as tight a correlation between asset size and cost when comparing IRA expenses. The variables typically are: the type of organization (bank, brokerage firm, insurance company, investment advisor), the type of product or program (direct or bundled), and the type of service required (fully managed, advised, do it yourself). The IRA rollover environment may include font-end sales charges, contingent deferred sales charges, a layer of consulting fees, early liquidation fees or just a straight investment management fee. When trying to sort out the differences, be sure you are comparing apples to apples and that all the details are on the table. In addition, IRA providers may charge an annual fee for IRA custody.

Armed with the fee disclosure document from your 401(k) program, it should be fairly simple to compare your current situation with what is being proposed in an IRA rollover program. However, unless you are dealing with a financial services firm acting as a fiduciary you may not be made aware of conflicts of interest that could work against you. Assuming that your current 401(k) is well run and has an attractive cost structure, retiring individuals with smaller 401(k) account balances that want ongoing investment guidance may experience lower overall costs staying in their 401(k), while individuals with larger balances have the opportunity to seek out more customized services and/or lower costs.

Access to Funds Within Retirement Accounts

There are also different rules governing withdrawals from 401(k) plans and IRAs.

Retirement Distributions: If your company’s 401(k) plan has a normal retirement age earlier than 59 ½, you will be able to begin penalty-free retirement distributions from your 401(k) account earlier than from an IRA. Once you roll your 401(k) into an IRA (rollover or contributory), you are subject to the IRA rules on distributions, which could be more restrictive.

Forced Distributions: The year after you reach the ripe age of 70 ½, you must take a required minimum distribution (RMD) based on the combined value of all your retirement accounts. However, if you're still working at age 70 ½, you typically don't need to comply with the RMD rules for 401(k) assets held with your current employer. It is important to note that highly compensated individuals aren't typically eligible for this special exception.

Plan Loans: If your 401(k) plan has a loan provision that is extended to retiring participants, you would be able to access 401(k) funds before retirement age without a penalty or tax impact at what is typically a very reasonable interest rate. By law you can only borrow up to 50% of your 401(k) balance, with a maximum loan of $50,000. While this is not a usual provision, it may be a customized feature. Be very careful with plan loans as the amount of the loan can become reclassified as a distribution, which could create tax and early distribution liabilities, should you leave employment prior to paying the loan back.

Special Distributions: For IRA monies: first time home buyers can withdraw up to $10,000 for the purchase of home, and the cost of qualified schooling for yourself, your spouse, your children and grandchildren can be withdrawn. Both type of withdrawals while penalty free, are considered taxable income. For 401(k) monies: an individual qualifying for a hardship may withdraw funds to cover the hardship expense. However, the amount is both taxable and may incur a 10% penalty unless one of the following exceptions is met by the participant: they are disabled, their medical debt exceeds 7.5% of adjusted gross income or they are required by court order to give the money to a divorced spouse, a child or a dependent.

In the next part of this series, we'll further discuss how investment advice, investment options and other issues need to be considered before rolling over a 401(k). (For more from this author, see: Why a Long-Term View Is the Key to Investing Success.)