Weighing the Pros and Cons of Rolling Over Your 401k to an IRA

Rolling over a 401k to an IRA can be a wise decision, but it is important to weigh the pros and cons before doing so. While a 401k is a retirement plan sponsored by employers that allows employees to save and invest a portion of their paycheck on a tax-deferred basis, an IRA is a tax-advantaged investment account that individuals can set up independently to save for retirement. When you leave an employer, there are a few options in terms of what to do with your 401k: you can choose to roll it over to an IRA, keep your assets in the current plan, roll your assets into a new employer’s 401k plan, or take a fully taxable distribution of assets from the plan.

Here are some advantages and disadvantages of rolling over a 401k to an IRA.

Pro:  More Control Over Your Investments

With an IRA, you can choose and manage your investment mix, adjust your risk tolerance, and even invest in individual stocks or bonds. You can implement “asset location,” which is the strategy of putting less tax-efficient investments in your IRAs and more tax-efficient investments in your taxable accounts, rather than buying the same holdings across all accounts. You can rebalance your portfolio at opportune times and make thoughtful decisions about which investments to sell to raise funds for withdrawals.

Pro:  More Investment Options

An IRA offers a wider range of investment options, including individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and even alternative investments like real estate or private equity. This flexibility can help you tailor your investments to your specific needs, tax situation and risk tolerance.  Most 401k plans have a solid lineup of stock funds, but fewer options when it comes to bonds, which makes sense since 401k plans are typically focused on encouraging participants to accumulate as much as they can. As you near retirement, you’ll likely want to shift to a less aggressive mix of investments and hold a more diversified bond portfolio.

Pro:  Availability of Low-Cost Investment Options

Smaller 401k plans often use investment options with higher expense ratios, as part of those fees are used to offset the administrative costs of running the plan.  Larger 401k plans are more likely to utilize lower-cost investment options and cover the administrative fees separately.  By rolling to an IRA, you can avoid the administrative fees of the 401k plan.  While your management fees on an IRA may be higher than a 401k, those fees should provide access to comprehensive investment, financial planning, tax and estate planning and other wealth management services.

Pro:  Ability to Do Roth Conversions and Take Qualified Charitable Deductions

Once your 401k is rolled over to your IRA, you can convert specific dollar amounts or specific shares by transferring those positions directly from your IRA to your Roth IRA. After retirement and before you start drawing Social Security is often an optimal time to pursue Roth conversions. Additionally, for those over age 70.5, you can make tax-free withdrawals from IRAs to donate to charity. These options are not available in a 401k plan.

Pro:  Better Communication and Simplified Recordkeeping

Consolidating multiple 401k accounts from different employers into a single IRA can simplify recordkeeping, address changes, and performance monitoring, making it easier to manage your overall retirement savings.

Pro:  Beneficiary Designation and Estate Planning Advantages

Consolidating 401k accounts with your IRA also makes it easier to review and update beneficiary designations as your estate plan evolves. Upon your death, there’s a good chance that your 401k will be paid in one lump sum to your beneficiaries, which may not be optimal from a tax perspective. Rules vary depending on the plan, but most companies prefer to distribute the cash quickly, so they don’t have to maintain the account.

Here are the disadvantages of rolling over a 401k to an IRA.

Con:  More Limited Creditor Protection

A 401k plan generally provides more creditor protection than an IRA. This is because 401k plans are governed by the Employee Retirement Income Security Act (ERISA), which provides certain protections against creditors. For example, ERISA shields 401k plans from creditors in case of bankruptcy or litigation. While IRAs are generally protected if you file for bankruptcy, state laws vary with respect to other types of claims. For example, some states may not offer protection for IRAs in cases of lawsuits or other legal judgments.

Con:  Delayed Access to Funds

401k plans may allow penalty-free withdrawals under specific circumstances, such as separation from service after age 55, which may not be available with an IRA. This exemption does not apply to IRA accounts, as you must wait until 59 ½ to make withdrawals from an IRA without paying a penalty.  Additionally, with a 401k, you can typically take out a loan against your balance or make a hardship withdrawal in case of an emergency. These options are not available in an IRA.

Con:  Higher Fees in Some Cases

While IRAs can offer lower fees in some cases, some investment choices or an advisor’s management fee may result in higher fees compared to a 401k plan. Depending on the plan, sometimes rolling a 401k to an IRA can reduce costs and / or produce higher levels of financial planning advice for similar cost.

Con:  May Not Make Sense to Continue Back-Door Roth IRA Contributions

If you are still employed and want to continue making “back door” Roth IRA contributions, this strategy may not make sense after you rollover your 401k. The “back door” Roth IRA strategy is where you make an annual non-deductible contribution to your traditional IRA and convert the entire amount to your Roth (which is typically tax-free if done correctly). This strategy may no longer be advantageous after you rollover your 401k because funds in a 401k are typically pre-tax. Once they are rolled into your IRA, they will be included in the pro-rata calculation that determines how much of your Roth conversion is taxable.

Con:  Less Favorable Tax Treatment for Net Unrealized Appreciation (NUA)

If you hold employer stock in your 401k, you may be able to take advantage of a tax-saving strategy called net unrealized appreciation (NUA) if you distribute the stock as part of a lump-sum distribution. However, if you roll over your 401k to an IRA, you lose the ability to use NUA.

How to Decide

Rolling over a 401k to an IRA can provide more control, better investment options, and access to more robust tax strategies, as well as other advantages like better communication, simplified recordkeeping, and estate planning benefits. However, there are also potential drawbacks to consider, such as limited access to funds, higher fees in some cases, loss of creditor protection, loss of ‘backdoor Roth’ strategy, and less favorable treatment for NUA. It is important to evaluate your individual situation and consider all options before deciding. It may be helpful to consult with your Wealth Management team and tax professional to determine the best course of action for your retirement savings.