If you’ve left your job or simply just have an opportunity, should you rollover your 401k? In this blog post, I outline when it’s appropriate to rollover your 401k and when it’s appropriate to keep your 401k in place.
3 REASONS TO KEEP 401K IN PLACE
In my mind, there are only 3 reasons why you should keep your money at the 401k level:
1. You plan to retire between ages 55 and 59 1/2: If you retire between these ages then a 401k allows you to withdraw money without it being subject to a 10% penalty tax. An IRA on the other hand would penalize you 10% if you took money out before age 59 1/2. However, there is a way around this through an IRS provision known as Rule 72(t), but that is a conversation for a different day.
2. You need to borrow money: If the idea of possibly needing to borrow money from your 401k is appealing to you, then your 401k may allow this provision (note that not all 401k plans allow loans). IRAs do not allow for loans to be taken. However, you should be careful when taking a loan out of your 401k. It should be considered a loan of last resort due to the complications that could arise. One of the major questions that arises when taking a loan is this: If you needed money in the first place, and you borrowed from your 401k, then how will you be able to pay yourself back? If you don’t pay yourself back, then the money you borrowed becomes taxable and you likely won’t have money to pay the tax which is why you borrowed money in the first place. You see, it’s a vicious circle.
3. 401(k)s typically have greater protection from creditors IRAs: 401(k)s are governed by federal law and are completely protected from creditors in both bankruptcy and non-bankruptcy situations. IRAs unfortunately operate a bit differently. IRAs have federal protection of $1,283,025 in bankruptcy situations and further protection could be provided depending on the laws of the state in which you reside. For non-bankruptcy situations, the amount of IRA creditor protection is also determined by state laws. In my home state of Missouri, for example, IRAs are fully protected from all types of creditors (bankruptcy or not). However other states may not afford this same protection. Be sure to check with a qualified attorney in your state to specifically determine if your IRA is shielded from creditors. One last point. Your IRA and 401k assets could be subject to the IRS if you owe them money or to your ex-spouse as part of divorce proceedings.
10 ADVANTAGES OF ROLLING OVER YOUR 401(k) TO AN IRA
There are many reasons why you may want to consider rolling over your 401k:
1. More investment choices in an IRA: I’ve seen really large 401k plans that only offer a handful of choices. With IRAs, you are free to invest into virtually whatever you want. This could potentially allow you to more properly diversify your portfolio and reduce the risk your take.
2. Control: 401k plans control which investments you have access to. So, if you absolutely love a particular investment, it could be taken away from you and replaced with something else. With an IRA you control which investments you want to use or not.
3. Consolidation: Having multiple 401k plans can be an organizational nightmare. You receive multiple statements, have to invest each 401k separately, have multiple beneficiaries to keep track of, etc. Consolidating them all to a Rollover IRA would be a way to simply your life financially.
4. Multiple RMD payments required for each 401k you own: If you are age 70 1/2 or older and have multiple 401k plans, you will have to receive the IRS mandated required minimum distribution (RMD) from each account separately every year. This is not an issue even if you had multiple IRAs. You could take the RMD from just one IRA to satisfy the RMD for all of your IRAs.
5. IRAs allow you to use funds for higher education costs without being subject to a 10% penalty: This benefit is not available with 401k plans. Additionally, the benefit is not only available to you as the IRA owner but is also available to your spouse, children, foster children, adopted children, or an descendant of them.
6. Funds from an IRA can be used to pay medical insurance premiums for unemployed people without being subject to a 10% penalty: If you happen to be laid off and are short on funds, then this little provision could be of benefit to you. 401k plans do not allow this.
7. Up to $10,000 of funds from an IRA can be used to buy a first time home and not be subject to a 10% penalty: You may be thinking that a first time home buyer is someone who literally buys their first home, but that is not the IRS definition. In actuality, you are considered a first time home buyer if you have not owned a home within the last 2 years. This benefit is not available to 401k plans.
8. The ability to stretch a 401k over a beneficiary’s lifetime is not always available in a 401(k): Stretching out a 401k refers to the beneficiaries’ ability to take out only a small portion of the 401k each year (RMD) over their life expectancy. However, some 401k plans require beneficiaries to receive the 401k in a lump sum or over 5 years. This means that the entire balance of the 401k will be taxable over a short period of time which will possibly push your beneficiaries into a much higher tax bracket. If the money were in an IRA instead, the beneficiaries could slowly withdraw the money over their life expectancy, and not have to pay tax all at once. This is a tremendous provision that could allow an account to grow to a much larger amount due to the tax deferral. By the way, this only applies to non-spouse beneficiaries, not spousal beneficiaries. Spouses can choose to treat the 401k as their own asset and avoid RMD until their age 70 1/2.
9. You could be prohibited from trading in a 401(k): This is a very scary thought. During the days of Enron, they had changed 401k administrators and this prevented employees from selling their Enron stock while it was plummeting in value. Can you imagine the horror of watching your investment (and for many people they likely had a lot of money in Enron stock) go down rapidly and not being able to do anything about it? This goes back to the issue of “Control” mentioned above. If you had your money in an IRA instead you wouldn’t have issues like this.
10. 401k withdrawals are subject to mandatory 20% withholding tax: My guess is that you did not know this. Even if you didn’t want tax withheld, you have no choice in the matter. This is problematic on a couple of fronts. First, what if you aren’t in a 20% or higher tax bracket? Well, you’d have to wait until April tax time to get any additional tax back. Second, what if you have enough tax already being withheld from other sources and you don’t need tax withheld from the 401k withdrawal? Once again, too bad! You’ll have to wait until tax time to get your refund. You would not face this problem if your money were in an IRA. If you didn’t want to have any tax withheld, you wouldn’t have to.
As you can see, there are reasons to keep your money at the 401k level and reasons to roll it over to an IRA. In summary, if you value unlimited creditor protection, want to have the ability to borrow money from your 401k, or plan to retire before age 59 1/2, then keeping your 401k in tact may be the best decision for you. Otherwise, if you value control, increased investment options, consolidation, or one of the other benefits discussed above, then you should possibly rollover your 401k to an IRA.
If you’ve been on the fence about what to do with your 401k, then hopefully this blog post has been helpful.
Please feel free to share comments, questions, or experiences below.
If you’re new to our blog and wish to receive weekly financial planning tips, please sign up for our eContent.