As with most things finance, the answer is that it depends. Mostly, it depends on your age, why you are leaving, and what you plan to do or may need to do with your 401(k) account. Generally speaking, a rollover 401(k) account can be a good option. However, there are times you should seriously consider not rolling over your 401(k) account.
Let’s look at a few times it makes sense to do a rollover of your 401(k) account to an IRA and what those benefits may be for the account holder.
First, rollovers are generally free! Most IRA providers do not charge you a fee to do a direct, trustee-to-trustee rollover from your employer 401(k) to an IRA account. This doesn’t mean that there might not be other fees to consider such as fees for advice, or with mutual funds you may have expense ratios, management fees such as 12b-1 fees, or possible sales charges referred to as “loads”.
A rollover to an IRA could provide you with greater investment options. Frequently, employer 401(k) plans are limited to employer stock (which you likely should not rollover to an IRA, but more on that later) or a selection of funds from which to choose. With an IRA, you will likely have a vast array of mutual funds to choose from and may be able to include ETFs and individual stocks. This variety provides greater planning opportunities for diversification.
Rolling over your 401(k) to an IRA also gives you consistent rules outlined by the IRS. Many 401(k) plans have different rules adopted by the employer, but with an IRA the rules are consistent from provider to provider.
Now let’s look at a few times it makes sense not to do a rollover of your 401(k) account to an IRA.
As noted above, if you have company stock in a 401(k) account you likely will not want to rollover the stock to an IRA. If you do, you will lose a tax planning advantage known as NUA (net unrealized appreciation). Basically, you want to move the company stock to a taxable account so that you do not pay ordinary income tax on the stock’s net unrealized appreciation. The goal generally is to pay ordinary income tax on the value of the company stock at the time it was added to your 401(k) account. How the NUA amount on the stock is taxed at sell depends on when you sell the stock. You may sell immediately and capture the lower capital gains rate, or you can decide to hold the stock. If you decide to hold the stock, you have a new clock ticking and need to wait at least a year on the new gains before selling and taking advantage of the lower capital gains rate. Timing and planning are critical to your goal so consult with your adviser prior to executing any move.
Are you age 55 or older when you separate from service? In this case, the 10% penalty for early withdrawal will not apply to withdrawals from your 401(k). Depending on your individual circumstance, this may be an advantage to not rolling over your 401(k) account to an IRA. Separation from service includes being fired, laid-off, or quitting your job. Keep in mind that it is the separation from service at age 55 or older that is important. The IRS says distributions, “made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55,” are not subject to the 10% early withdrawal penalty. This treatment does not apply to an IRA so if you rollover your 401(k) account you lose this planning option.
Another reason not to rollover your 401(k) account is greater legal protection. 401(k) accounts have stronger federal law protections from creditor liens and judgments than do IRAs which fall under state law protections which vary. This protection does not include IRS tax liens and possibly spousal or child support, so keep that in mind. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, does protect up to around $1.2 million (inflation-adjusted) in traditional or Roth IRA assets against bankruptcy but other types of liens and judgments vary by state. So, depending upon your situation, leaving your 401(k) account intact with your former employer could provide greater safety.
Deciding whether to rollover your 401(k) account to an IRA is a big decision. If you are not sure what to do, spend some time discussing your goals and intent with a financial planner. As an independent Certified Financial Planner™, I can help you decide how to move forward based on your personal situation and goals. Contact me and let’s get started!
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