What are the disadvantages of rolling over a 401(k) to an IRA?

While the advantages of rolling a 401(k) are well documented, it’s always a good idea to consider the other half of the equation. It’s certainly true that moving an old 401(k) to a new IRA has its upside: consolidation, lower fees, more control, and usually more investment options. However, like with almost anything in personal finance, there’s rarely ever a perfect solution.

Here, we’ll explore the disadvantages of rolling over an old 401(k) to an IRA.

When is rolling over a 401(k) not worth it?

There are a number of circumstances that may make rolling over your 401(k) less than ideal:

Your old 401(k) has no glaring issues.

Specifically, this means that your 401(k) plan (from a previous employer, as you’re not able to roll a current 401(k) into an IRA) charges no excess fees and offers a low-cost investment menu. If your old 401(k) is no better off in an IRA than in its current state, there’s no real reason to move it.

You plan to retire at 55.

Money in a 401(k) benefits from the “Rule of 55”, which allows penalty-free withdrawals from your 401(k) plan as long as you’re age 55 and retired. While this won’t eliminate the tax hit when you do withdraw the money, you’ll be able to take advantage of this Rule with your 401(k) — but not with your IRA.

You want to roll your 401(k) into a Roth IRA.

Unless you’re starting with a Roth 401(k), rolling a pre-tax 401(k) to a Roth IRA can result in a five- or six-figure tax bill depending on your total balance. If your circumstances call for such a rollover (it’s rare), be sure to speak with a tax advisor first.

You value the increased creditor protection.

401(k)s, relative to IRAs, tend to be more protected from a legal standpoint. Should you ever need to file bankruptcy, the 401(k) is preferred to your IRA in terms of keeping all your assets.

You’re interested in advanced financial planning.

When you have a 401(k), you can sidestep the “pro-rata rule”, which has to do with converting pre-tax IRAs to Roth IRAs. If Roth conversions are in your future (as they would be if you use “backdoor Roth” conversions), keeping the 401(k) is a stealthy way to reduce your tax on conversion. Note that this is an advanced financial planning topic.

You haven’t considered the consequences.

Try to be careful around retirement account rollovers, as they can often result in unintended tax consequences. Make sure to think through any rollover activity before you begin one — it’s worth the extra time!

Can you roll a 401(k) into an IRA without penalty?

First, it’s important to remember the difference between a penalty and a tax consequence. Penalties are levied when you do something that you’re “not allowed” to do; taxes are imposed when you declare money as current-year income (which can happen whether you meant to do it or not!). So one of the main goals when rolling over a 401(k) is to avoid both taxes and penalties, which is both achievable and not too difficult if you’re careful.

Next, there’s also a big difference between rolling over money and withdrawing it. Usually, rollovers do not result in penalties, but withdrawing money early most certainly can. Rollovers may result in taxes charged, but this can be avoided with some diligent planning. On the other hand, withdrawals will almost always carry a tax charge unless the money is coming from a Roth 401(k).

So the short answer is yes, you can roll a 401(k) into an IRA without penalty — as long as you roll your 401(k) into a “like-tax” IRA. To avoid tax, you’ll need to ensure you roll your pre-tax 401(k) into a pre-tax IRA (typically referred to as a traditional IRA).

One rollover activity that would cause a tax hit is if you were to try to roll a pre-tax 401(k) to a Roth IRA. Because these accounts are not “like-tax” — the 401(k) is pre-tax and the Roth IRA is post-tax — you’ll be liable for ordinary income tax on the entire amount rolled over. This is a prime example of why due care is needed when attempting any rollover.

Do you lose money when you roll over a 401(k)?

Generally, no. Although there could be some minimal loss if you were to roll money over and the stock market were to rise generously when the rollover was “in transit” between accounts.

When you roll over your 401(k), you liquidate (sell) all of the investments in the account. This effectively takes you out of the market.

When the rollover arrives into your new IRA, it will arrive in the form of cash, and it will be up to you to invest it. The time between the sale of your old investments and the purchase of your new ones could result in some loss of market growth, but it could also result in a gain if the market falls during this 1-2 week period.

You also can “lose money” in the form of taxes, but this is avoidable as previously mentioned.

When you think about a carefully planned 401(k) rollover, there is really no reason to be concerned about losing money.