For many years the best action to take with a 401(k) account when leaving an employer was to roll over the account to an IRA.
The rollover has been the most frequent IRA transaction, and rollover contributions exceed regular contributions by a significant amount.
But the situation has been changing. An IRA rollover is the best action less often, and people seem to realize that.
A recent study from J.P. Morgan found that three years after retirement about 42% of participants still had their money in the employer plans, about double the number 10 years ago.
T. Rowe Price found that 83% of current 401(k) participants are interested in keeping money in the plans after retiring. In a Pew Institute survey, 35% of near-retirees said they intended to keep their assets in their employer plans.
One reason for the shift is employers and the financial firms that administer their plans changed. In the past, they didn’t want to deal with the headaches of communicating with former employees. But technology makes that easier.
Also, employers and administrators realize retaining accounts reduces costs, leading to a better plan. A recent survey by PIMCO found that about 75% of sponsors of large 401(k) plans now prefer that retiring employees keep their assets in the plans.
Regulations are another factor. The Department of Labor issued several sets of regulations about IRA rollovers in the last 10 years or so. The regulations were controversial and invalidated by the courts, but they were intended to discourage rollovers.
The Securities and Exchange Commission also tightened its regulations concerning IRA rollovers.
The result is many financial advisors became wary of providing advice about rolling IRA rollovers.
Whether or not to roll over 401(k) assets is one of the more significant retirement decisions. A simple process can be used to determine the best choice.
A departing employee usually has these options for a 401(k) account: leave the money in the 401(k) plan; transfer it to the 401(k) plan of a new employer, if the new plan allows; have the account distributed directly in a lump sum; or roll over the account to an IRA.
I’m going to assume you’re retiring, so transferring the money to a new employer plan isn’t an option.
Taking a lump sum distribution usually isn’t a good idea, because the entire amount would be included in gross income and taxed in the year of the distribution. That usually isn’t wise unless you really need the cash.
But a lump sum distribution can be a wise choice when the 401(k) holds appreciated employer stock. Then, the employee might be eligible for a special tax break known as net unrealized appreciation (NUA) that involves taking a lump sum distribution of the stock and rolling over the rest of the 401(k) to an IRA.
For most retiring employees, the choices are to stay with the 401(k) plan or roll over the account to an IRA.
To decide, examine the features of the 401(k) plan.
Though most 401(k) plans improved a lot over the years, many still aren’t attractive on their own. That’s more likely to be the case with plans at small- and medium-size employers.
An attractive plan has low expenses.
Most plans have an annual fee on each account, often called a maintenance, recordkeeping, or administrative fee.
In addition, the investment funds offered by the plan have their own fees and expenses.
There might be other expenses, and the expenses are disclosed in documents issued by the plan (or available on its web site).
Many employers, especially large employees, work hard to drive down plan costs, especially investment management fees. Their plans invest in the “institutional shares” of funds, which charge the lowest fees of any share class. Some employers also subsidize other costs, such as recordkeeping and administration fees.
Review the documents and learn the plan’s costs to you.
Next, consider the investment options.
A good 401(k) plan offers more asset classes than the basic five or fewer that some plans offer. The funds also should have consistently good long-term performance compared to similar funds.
Some 401(k) plans have funds from different investment management firms, while most of the funds at other plans are from one firm. What matters is that the funds deliver good performance for reasonable fees.
Most IRAs, on the other hand, allow you to invest in almost any publicly-traded security or fund plus some other opportunities. You might prefer that to the limited menu of the 401(k) plan.
The IRA probably won’t have an annual maintenance or administrative fee.
You need to weigh the value of the large number of investment options offered by an IRA with the potential that the 401(k) plan’s funds charge lower expenses.
When you’re a fan of target date funds or similar asset allocation funds, review the ones offered by the 401(k). Some 401(k) plans have customized target date funds that offer advantages over the retail funds. But many 401(k)s offer the same funds available through an IRA, though expenses might be lower.
A 401(k) plan might have a brokerage window that allows you to invest at a reasonable cost in most or all of the investments available through the broker selected by the plan.
A 401(k) plan could have a stable value fund option that you find attractive.
More 401(k) plans are adding annuity options for those who want to convert all or part of their accounts into guaranteed lifetime income. You also can buy an annuity through an IRA. But 401(k)s often negotiate better annuity terms than are available to individual retail buyers.
Compare current payouts available from the plan’s annuity to those you could obtain from insurers as an individual buyer.
Also, consider the policies and rules of the 401(k) plan.
Some plans limit how often investments can be changed and when money can be taken from the plan. Learn about any such limits and decide if they’re important to you. Most IRAs don’t have these restrictions.
Examine the distribution options for both you and a beneficiary. Some 401(k) plans offer limited ways to take distributions while others offer the same flexibility as most IRAs.
Another consideration is that staying with the 401(k) plan might prevent you from consolidating your investment assets at one financial services firm.
Try to find out how easy it will be to communicate with the 401(k) plan after retiring. Active employees have access to the employer’s internal email and other electronic services that might not be readily available to retirees and other former employees.
When considering an IRA rollover, look beyond IRAs offered by the 401(k) plan administrator. There might be lower-cost, more flexible IRAs available from other firms.
Either an IRA or 401(k) might charge fees for various transactions. Take a look at the list of fees for transactions such as distributions, rollovers, issuing checks, and more.
A good way to compare the alternatives is to decide the types of assets you’re likely to invest in and the transactions you’re likely to make in the future. Then, decide which vehicle seems the best fit for that profile.
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