One of the primary ways to save for retirement is through your employer’s 401(k) plan. When you change jobs, you’ll have the option to move your 401(k) funds into an Individual Retirement Account (IRA), roll them into a new employer’s retirement plan, or keep the money with your former employer.
Since retirement readiness is often a primary personal finance goal and requires a significant portion of most people’s savings, this transition presents a great opportunity to evaluate all your options to ensure you’re set up for success. We’ll explore several important factors so you can determine the best move for you.
Your old employer’s 401(k) plan is managed by a plan administrator that determines what kinds of assets — like exchange-traded funds (ETFs), index funds, or mutual funds — you’ll be able to invest in. The portfolio menu will vary substantially from plan to plan and can have meaningful limitations in terms of diversification, fees, and risk preferences.
By choosing to move your money to an IRA, you’ll have the option to select your own brokerage — the financial institution that hosts the new account — which will allow you to invest in a much broader universe of funds and portfolios that may better align with your goals.
Optimizing the amount you pay in portfolio fees is one of the major areas you have influence over when saving for retirement. 401(k) fees can range between 0.37% to 1.42% or more (annually) depending on your plan. IRA account fees have the potential to be much lower on an annual basis. While the fee percentage difference may seem small, this difference can add up over the years and can have a large impact on your portfolio value by the time you decide to retire.
Management fees are not the “be-all-end-all” when making your retirement investment decisions. However, when evaluating your relationship with a financial institution, it’s smart to ensure you’re getting the best value for your money — all while minimizing the fee impact on your portfolio. After all, lower costs mean more money for the important stuff: actually retiring.
You’ll probably change jobs multiple times throughout your career. If you contribute to different 401(k) plans at various stops along the way, you’ll quickly accumulate additional retirement accounts that will vary in fund selection, fees, and portfolio strategy — which can make financial planning all the more difficult.
Your old 401(k) accounts may also change plan administrators over time, further complicating your ability to track your funds down easily. Consolidating these accounts in an IRA may not only give you peace of mind, but it can also ensure that your hard-earned retirement dollars are all moving in the same direction.
While employer-sponsored plans vary in service offerings, an IRA gives you the opportunity to direct your retirement savings toward a strategy that’s best aligned for you. This includes self-directed portfolio management, working with a financial advisor to manage your funds, or selecting a robo-advisor which can be seen as a hybrid between the two.
Regardless of your preference, with an IRA you’ll be able to align your retirement savings towards your personal goals and situation. Depending on how your 401(k) is set up, you may lack the flexibility to tailor the account to your liking.
In some cases, IRAs provide more accessibility than 401(k) accounts. One example is a first-time home buyer distribution. Typically you can’t withdraw from a 401(k) account balance before age 59 ½ without incurring a 10% early withdrawal tax penalty from the IRS unless you meet a specific set of criteria. You can, however, borrow money from your 401(k) — but this should be seen as a last resort.
With an IRA, in limited and unusual circumstances, you’re able to access up to $10,000 without paying the early distribution fee. There may still be tax implications, however: you may owe ordinary income tax on the amount you withdraw. While you might still opt to use savings from non-retirement accounts to purchase a home, an IRA gives you more flexibility to withdraw for a home purchase than an employer-sponsored 401(k) plan does.
Your former employer’s plan may allow for pre-tax contributions, Roth deposits, or both. (Quick reminder: traditional accounts allow your money to grow tax-deferred, which means you’ll pay taxes when you take distributions in retirement. Roth accounts, on the other hand, require you to pay taxes on the money before it’s contributed — but these funds can then be withdrawn in retirement tax-free.)
Whichever you choose, these contributions are locked into each respective tax designation once you’ve selected your preferred option. This can potentially limit your tax-planning strategy down the road.
By moving your pre-tax 401(k) balance to a traditional IRA (also a rollover IRA), you’ll have the option to convert these funds to a Roth IRA if you desire. You’ll have to pay taxes when converting pre-tax dollars to a Roth since the funds haven’t been taxed yet. Still, it’s helpful to know that Roth conversions are available so you can optimize your tax strategy moving forward.
While IRAs generally give more withdrawal flexibility than 401(k) accounts, IRAs don’t offer loan provisions. 401(k) accounts do give you the option to take a loan up to $50,000 or half of your vested value, whichever is less. The loans must be paid back into the 401(k) over a scheduled time period and agreement as laid out in the plan. Although most traditional investment advice states it’s best to keep funds earmarked for retirement set aside to ensure you stay on track, there may be edge cases where having a loan option is helpful.
The Employee Retirement Income Security Act (ERISA) of 1974 provides certain creditor protections for funds held in employer-sponsored retirement accounts, including 401(k)s. This protection is not extended to IRA savings (with the exception of bankruptcy). While this is something you hopefully won’t ever have to experience, these distinctions are important to note.
Your personal retirement timeline is a crucial goal to consider when deciding between a 401(k) and IRA. Both accounts allow you to take penalty-free distributions at age 59 ½ to avoid the 10% early distribution tax. With 401(k)s you can access retirement funds even sooner without penalty thanks to the Rule of 55. If you’re laid off or retire in the calendar year you turn 55 or after, you can access your current 401(k) without the 10% early withdrawal penalty. There may be other specific rules you’ll need to follow to ensure you avoid the 10% penalty, but this presents an intriguing option if your desired retirement age is less than 59 ½. IRAs have no such feature.
401(k) plans have an extra layer of protection due to the fiduciary responsibilities of your plan manager. This means that the management must act only in the best interests of all the plan participants and must also avoid conflicts of interest. Institutions that offer IRAs may or may not act in this capacity. If you choose to move funds to an IRA, this is an important feature to consider, since you’ll want to be sure your retirement funds are in good hands.
If you decide to move your previous employer’s 401(k) to an IRA, the next step is understanding the process so you can ensure a smooth transition. Transferring, or rolling over, your funds follows several steps that may vary a bit depending on each institution’s policies. We’ll walk through the rollover process together so you know what to expect.
The most seamless rollover option is a direct rollover. In this method, the proceeds are made out to the IRA for your benefit and sent directly to the institution. To get started, first, confirm with your IRA provider the details necessary to move your funds over. This information may include an account number, address, and dollar amount.
Next, get in touch with your former employer’s 401(k) plan administrator to provide these instructions and confirm the requirements necessary to move your account elsewhere. You may be able to accomplish this with a simple phone call or be required to sign paperwork authorizing the transfer. Once your former employer has been properly notified of your intent, the funds will be sent directly to your IRA or to you for forwarding to your IRA provider.
Another transfer option is an indirect rollover — sometimes called a 60-day rollover — which is when you request your old 401(k) proceeds be made out directly to you. Once the transfer is initiated, you have a 60-day window to deposit the funds into an IRA.
Failing to re-deposit the money into a tax-advantaged account can be costly. You’ll incur potentially hefty penalties and fees, including a 10% early withdrawal penalty (if you’re younger than 59 ½) and have taxable income in the amount of your gross distribution.
You’ll also be subject to mandatory tax withholding of 20% as the relinquishing institution assumes you are cashing out the account. An indirect rollover should only be pursued if you know you’ll be able to re-deposit the funds (gross of any tax withholding) within a 60-day window.
While you may not be feeling too eager about rolling over your 401(k), it is becoming easier to make rollovers take place. Our mission is to help facilitate this process quickly and efficiently by providing step-by-step support to ensure your rollover is completed smoothly.
Retirement is one of the major milestones most people save for. The variables of your personal situation play a major part in determining whether to keep your money at your old 401(k) or move the funds to an IRA. As a result, carefully consider all the factors involved so you can make a decision that aligns with your retirement goals.
For many reasons, rolling over a 401(k) into an IRA can be an attractive option as it generally gives access to more investment choices, can reduce your fees, and can give you more peace of mind by having your retirement savings in one place.
If your former employer’s 401(k) is low-cost, aligns with your investment strategy, and you’re not concerned with losing track of the account in the future, then keeping your funds in place may be reasonable as well.
Either way, once you’ve left an employer, you have more control over determining how to optimize your retirement savings.
If you feel you need some extra help when it comes to organizing your rollover, we’re here to help. You can also consider consulting with a qualified tax advisor for additional expertise.
Get started with Capitalize today and we’ll manage the entire process so that you don’t have to.