Don't Roll Over Your 401(k) To an IRA Just Yet
You've left your job. What should you do with the 401(k) plan you've faithfully contributed to for years? Conventional wisdom says to roll it over into an individual retirement account (IRA), and in many cases, that is the best course of action. But there are times when a rollover is not your best option.
Let's take a look at five of those situations and the rationale for keeping your 401(k)—or, if you're a public or nonprofit employee, your 403(b) or 457 plan—in place at your now-former employer's plan.
- Leaving your 401(k) account with your employer can save you fees since the company can buy funds at institutional pricing rates.
- If you own appreciated company stock in your 401(k), transferring the stock to a brokerage account instead of an IRA can save on taxes.
- Not rolling over your 401(k) can help with legal protection in bankruptcy and provide access to your money at an earlier age.
- Company 401(k) plans have access to stable value funds, which are similar to money market funds, but offer better interest rates.
1. Greater Buying Power
Company 401(k)s can purchase funds at institutional pricing rates, which is not usually true for IRAs.
Think of it as a kind of corporate discount: Because they're investing for hundreds of thousands, "most 401(k), 403(b), and 457 plans have significant buying power—much more than the individual [retirement account]," says Wayne Bogosian, ex-president of the PFE Group and co-author of The Complete Idiot's Guide to 401(k) Plans. That can save you significant money on fees, leaving more to appreciate in your account.
2. Tax Savings
If your 401(k) plan includes company stock that has greatly appreciated, you could save a lot on taxes if you transfer that stock to a regular brokerage account. You will have to pay taxes on the shares taken out of your 401(k) at your current bracket's rate; however, the tax is based on your original purchase price—you won't pay for any gain on that stock until you actually sell it (and then you'll pay at the capital gains tax rate, which is lower than the income tax rate). This is known as net unrealized appreciation (NUA).
"NUAs is a tremendous opportunity for individuals with appreciated company stock in their 401(k)," says investment advisor representative Jonathan Swanburg of Tri-Star Advisors in Houston, Texas.
Let's suppose, for example, the company stock was bought for $10,000 and is currently worth $50,000 on the market. Your tax bill for transferring the stock to the brokerage firm will be based on the $10,000 purchase price. You won't be taxed on any of the gains until you sell it. Because the stock is being sold in a brokerage account, when you do sell it, it will be taxed at the more favorable capital gains tax rate, versus the ordinary income tax rate.
In contrast, if you rolled over that stock into an IRA, it would eventually be taxed at your ordinary-income tax rate when you have to sell the stock to start taking your required minimum distributions (RMDs) from the IRA. RMDs begin at age 73 if you were born between 1951 and 1959 or 75 if you were born in 1960 or after.
There are, however, reasons to be cautious. Below are two:
- Make sure the holdings in your 401(k) are actual stock shares; some 401(k)s set up a fund that mimics the corporate stock's performance.
- Make sure the transfer of these holdings doesn't put such a sizable bump in your income that you get pushed into a higher tax bracket—and end up owing the Internal Revenue Service much more than you otherwise would come next April.
"If, on the other hand, a plan participant holds depreciated company stock that she plans to hold until the price goes higher, she should consider selling her shares and repurchasing them shortly thereafter," Swanburg adds. "Inside a 401(k), the wash-sale rule doesn't apply, and this resets the cost basis, increasing the potential for taking advantage of the NUA down the road."
Check with your company before deciding what to do with your 401(k) since you may not have the same access, fund-allocation privileges, or fees once you leave your job.
3. Legal Protection
Money held in a 401(k) is protected by federal law from pretty much all types of creditor judgments (other than IRS tax liens and, possibly, spousal or child support orders), including bankruptcy. IRAs are only protected by state law, whose shielding power varies.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 does protect up to $1 million in traditional or Roth IRA assets against bankruptcy. But protection against other types of judgments varies by state and may even be different depending on whether your IRA is a Roth or the traditional form.
If you are concerned about potential judgments, creditors, or collections, keeping your 401(k) funds in place might afford the most safety.
4. Early Retirement Benefits
"One of the most important reasons not to roll over your 401(k) to an IRA is to have access to your funds before age 59½," says Marguerita Cheng, CFP®, chief executive officer of Blue Ocean Global Wealth in Louisville, Ky. "They can be accessed as early as age 55, versus having to pay a 10% early withdrawal penalty in an IRA."
In fact, after you leave, you may be able to withdraw money from your 401(k) multiple times each year (the employer sets the rules about how many times people in this age group can withdraw funds). You lose this privilege once you roll the 401(k) into an IRA, and you'll have to wait until age 59½ to access your money without penalty.
However, there's an important exception to the early distribution penalty as part of IRS rule 72(t), which allows you to make withdrawals under the substantially equal periodic payment (SEPP) program.
If you're still working for your employer, SEPP withdrawals are not permitted from the qualified retirement plan; however, if you're separated from the company's service, you can qualify for this exception. The funds can also come from an IRA under SEPP at any time. The distributions are formulated as a series of substantially equal periodic payments over your life expectancy using IRS tables.
However, once you start SEPP payments, you must continue for a minimum of five years or until you reach the age of 59½, whichever comes later. If you fail to meet the requirement, the 10% early penalty will be levied, and you may owe penalties from prior tax years if you had taken distributions.
5. Stable Value Funds
Company 401(k) plans have access to a special type of fund called a stable value fund. Not available in the individual market, these funds are similar to money market funds, but they typically offer better interest rates. If you'd like to take advantage of these risk-averse vehicles, and your 401(k) offers them as an option, definitely stick to your current plan.
Can You Roll a 401(k) into an IRA Without Penalty?
Yes, you can roll a 401(k) into a traditional IRA without a penalty and without any tax consequences. If you roll over a 401(k) into a Roth IRA, there will be tax consequences. This is because a 401(k) is funded with pre-tax dollars while a Roth IRA is funded with after-tax dollars.
What Are the Disadvantages of Rolling Over a 401(k) into an IRA?
Some of the disadvantages of rolling over a 401(k) into an IRA include no loan options, a decrease in creditor protection, possibly higher fees, and the loss of a possible earlier withdrawal without penalty.
How Much Does It Cost to Roll Over a 401(k) into an IRA?
There is typically no fee or charge associated with rolling over a 401(k) into an IRA. It is possible that account fees in the new IRA account may be higher than the fees in the 401(k) account.
The Bottom Line
When you and your job part ways, deciding what to do with your retirement savings is a big decision. Rolling over a 401(k) may be the best option for you in most cases, but there are reasons why leaving the money in the company fund could work better.
Do check your company's rules, though: Most employers require your 401(k) to maintain a certain minimum sum if you want to leave the account in place after your employment ends, and there may also be differences in your access, fund-allocation privileges, and fees.
One other option to investigate if you want to keep your money in a 401(k) and you're leaving your old job for a new one: rolling over the money in your previous job's plan into the 401(k) at your new company, if that's permitted. This is an excellent option for older employees who want to protect that money from being subject to required minimum distributions (RMDs).
You don't have to take RMDs from your 401(k) at the company where you currently work. Just make sure that the new plan's fees aren't worse and that the investment options are comparable.