Have You Made This 401k Rollover Mistake?
Too many people make the mistake of assuming they should just rollover their old 401(k)s to a personal IRA. Or they may be sold on the benefits of doing this by a financial advisor whose recommendation contains serious conflicts of interest. If you are planning on an early retirement, this could be one of the biggest mistakes you could end up making.
Unfortunately, there is no simple answer. However, if you follow the steps below you can make sure you are making the best possible decision for your hard-earned retirement savings. If you make the wrong choice, you could end up costing yourself literally thousands of dollars in fees, or even additional taxes.
*When it comes to employer-sponsored retirement plans, 401(k)s and 403(b)s generally follow the same sets of rules, so for the purposes of this article we will simply refer to them as 401(k)s.
3 Steps To Making The Right Choice About Rolling Over A 401k:
Step 1) Make sure you are in the right frame of mind when making this decision.
If you find yourself wondering what to do with your retirement account because you just recently left your employer either voluntarily or involuntarily, odds are you have a thousand things running through your mind.
In my experience, this can cause one of two things to happen. Some people end up making a snap decision without researching what is best for them simply because it is easiest and takes the least amount of time. Others delay making any decision at all because their mind is preoccupied with numerous other concerns due to the job change.
Soon enough they have forgotten about the account and it ends up sitting there for years when there is a real chance they would have been better off rolling it into another employer-sponsored retirement account or an IRA. So, if you are in this position, set an actual calendar reminder for a few weeks down the road to research your options.
It is perfectly OK to do nothing with your account for this amount of time and this will give you an opportunity to get in the right state of mind and make sure you give this decision the proper amount of consideration it deserves.
Step 2) Understand Your Options.
Generally speaking, you have four options:
The best way to choose which option makes the most sense for you is to compare the costs, resources, and plan features of your 401(k)s to IRAs.
Step 3) Understand your 401(k) plan features.
There are a few things to consider when comparing your old 401(k) plan features with those of your new 401(k) or an IRA.
Every 401(k) has its own unique menu of investment options that you can invest your money in. While every plan by law is required to provide enough choices to enable you to be properly diversified, the costs associated with these investments can vary quite a bit from plan to plan. What costs should you be aware of?
The major costs will be expense ratios for the funds offered. An expense ratio reflects how much a mutual fund or an ETF (exchange-traded fund) pays for portfolio management, administration, marketing, and distribution, among other expenses. You'll almost always see it expressed as a percentage of the fund's average net assets (instead of a flat dollar amount). For example, if you invest $100,000 into a fund that has a .50% expense ratio, it will cost you $500 per year to be invested in that fund. As your invested balance grows, the dollar amount you owe for the expense ratio grows with it.
Expense ratios are not always obvious because they're not itemized on your account statements or confirmations. Instead, each fund's expenses are deducted from its total value on a regular basis. And those expenses cut directly into your investment returns. You can usually find them by logging into your account online and navigating to the menu of investment choices for your plan.
So what's a good expense ratio? In 2021 the average expense ratio for an actively managed fund that is trying to "beat" its benchmarks was .68%. For passive index funds that simply try to replicate the returns of broad market indexes, the average expense ratio was .06%. If you are finding that your 401(k) has active fund options with expense ratios closer to 1%, that's not a great plan. If the passive index funds offered have expense ratios closer to .10 or higher, that's not great either. If you are a passive investor who is comfortable owning ETFs, this could be a reason to consider an IRA, since you can't buy ETFs in a 401(k). ETFs typically have lower expense ratios than mutual funds.
The better plans will offer a wide range of low-cost, index-based investment choices. The lesser plans will only provide a small selection of actively managed mutual funds whose underlying costs can be as much as five times the costs of index funds.
Some plans even have what are called institutionally priced funds. This is a good thing. This means you are getting a group discount on the expense ratio of that fund as compared to owning the same exact fund in an IRA. If your old plan has a wide range of these inexpensive funds, you may be better off keeping your money there instead of rolling it into a new 401(k) or IRA with higher investment costs.
Sometimes, but not always, the plan can tack on what is known as administration fees. These are in addition to the expense ratios for the individual investments. Unlike expense ratios, these usually are listed on your statement.
Resources for helping you manage your portfolio.
Many financial advisors will try to sell you on rolling over your 401(k) to an IRA through them because they say they can “manage it better for you, “ but you must ask yourself what that even means. Are they saying they can consistently beat the market indexes over the long run? The majority of studies on this type of active investing prove this is highly unlikely, and you will most likely pay higher fees for this service in an IRA.
What some financial advisors may not want you to know is that many 401(k) plans provide either free or inexpensive tools and resources for helping you manage your portfolio with them. In addition to potentially low cost target date funds, this could include the ability to speak with a live rep who can provide you a recommended asset allocation (your mixture of stocks and bonds) or even a model portfolio that you can easily replicate yourself.
Some also offer ongoing professional management at a relatively low cost as compared to what you would pay for a similar service through a personal IRA provider. If having this type of help is important to you, ask both your past and current 401(k) service providers what types of resources they offer for helping you manage your portfolio and how much they cost, and then compare.
Typically, the fee for having an IRA portfolio professionally managed is around 1% of the assets under management. If you have access to a 401(k) plan that offers a similar service for a much lower fee, you may be better off keeping your money in that 401k
Not all 401(k) plans offer flexible distribution options. For example, once you separate from your employer, you can no longer take money out of the plan as a loan. You may also be faced with what is called a full payout only plan. In this type of plan, once you take any money out of your inactive 401(k), you are forced to take the rest out at the same time. You either must cash out the rest as a taxable distribution, or rollover the rest to another 401(k) or IRA tax deferred.
Some plans do offer what is known as systematic withdrawal payments. This means you can set up an automatic amount to be sent to you on a monthly basis. Just keep in mind that sometimes plans have weird rules about these systematic payments. For example, I have seen some that allow you to set them up, but once you do, you can not change the amounts. Or if you want to stop them, you have to rollover out of the account altogether.
Generally, an IRA is more flexible in that you can withdraw whatever amount you need, whenever you need to, as long as you are willing to pay the applicable taxes on the distribution. If you think there is a chance you may need to access any of the money in your inactive 401(k), you need to determine what types of withdrawal options are available in your plan.
Types Of Contributions
Many 401(k) plans only allow pre-tax contributions (you get a tax deduction now for making these contributions, but down the road when you withdraw, you owe taxes on the money. But some also allow Roth contributions (you do not get a tax deduction now, but down the road when you withdraw the money you don't owe taxes if you meet all the qualifications). If you have pre-tax money in your old 401(k), it's important to understand that if you roll it over to a Roth IRA , you will owe income taxes on that dollar amount.
On the other hand, if you have Roth money in your old 401(k), you would need to verify with the new 401(k) plan if they allow Roth money to be rolled into it. This is not always allowed. It it's not, you would either have to leave your Roth money in your old 401(k) or roll it to a Roth IRA.
Are You Making Backdoor Roth IRA Contributions?
If you roll an old 401(k) into a tax-deferred IRA and you are making Backdoor Roth IRA contributions, this will trigger the pro rata rule. Basically, this creates additional taxes when making Backdoor Roth IRA Contributions.
Age 55 Rule
Generally speaking, if you withdraw pre-tax money from a 401k or IRA before you turn 59.5 years old, you owe an additional 10% early withdrawal penalty on of top of normal taxes. But there is an exception to this rule that applies only to 401ks, not IRAs. It's called the Age 55 rule.
It states that if you separate from your employer during or after the year you turn 55, you can make penalty-free withdrawals from that specific 401k, without having to wait until you are 59.5. And you don't have to actually already be 55 when you separate from your employer. You just have to reach that age at some point in the same calendar that you left. For example, if you separate on March 1st, and you don't turn 59.5 until November 1st, you still qualify for the age 55 rule.
As soon as you rollover this money to another 401k or IRA, you lose that benefit. So it's extremely important to understand that if you qualify for it, you should take whatever money you need between age 55 and age 59.5, directly out of that 401k, before rolling the rest over somewhere else.
Net Unrealized Appreciation (NUA)
Some 401(k)s enable you to own company stock inside of them, whether that's through a profit-sharing contribution or your own election. If the current market value of that stock position grows to a much higher value than the total amount you actually contributed, there is an opportunity to save yourself a lot of money on taxes. When you take advantage of NUA, you basically end up rolling your company stock to a non-retirement brokerage account, and at the same time, you separate out the mutual fund portion of your 401(k) and roll it over to an IRA tax deferred.
When you do this, you owe ordinary income taxes on the total amount of contributions you made to that company stock (the cost basis). But the benefit is that once it's in the brokerage account you could end up paying long-term capital gains rates on the value of the stock that's above the cost basis. Historically speaking, most people pay 15% or even 0% taxes on long-term capital gains. If you keep the stock in a 401(k) or IRA and then sell it, you have to pay ordinary income tax rates on those amounts. And those rates can potentially be much higher than 15%. Not being aware of this opportunity when it presents itself is a huge mistake. And it's one that even some financial advisors aren't aware of.