Pros and Cons of Rolling Over a 401(k) to an IRA

Deciding what to do with a 401(k) from a previous employer is a common financial choice. A rollover involves transferring retirement savings from the employer-sponsored plan into a personal Individual Retirement Account (IRA), allowing for continued tax-deferred growth. The decision depends heavily on an individual’s financial situation and goals, making it important to understand the implications of moving the funds versus leaving them in the old plan.

Advantages of Rolling Over to an IRA

A primary reason for rolling over a 401(k) to an IRA is the substantial increase in investment choices. Most 401(k) plans offer a limited menu of options selected by the plan administrator, which can be restrictive. An IRA opens up a much wider range of possibilities, including individual stocks, bonds, thousands of mutual funds, and exchange-traded funds (ETFs). This flexibility allows for a more personalized investment strategy tailored to an individual’s specific risk tolerance and retirement timeline.

Another consideration is the potential for lower fees, as 401(k) plans can have multiple layers of administrative and fund costs. While large companies may offer low-cost funds, smaller plans can have higher costs that reduce returns. Rolling over to a low-cost IRA provider can mitigate these expenses, though careful comparison is necessary. The transparency among IRA providers often makes it possible to find a more cost-effective solution than a high-fee 401(k).

Consolidating retirement accounts is a practical benefit of an IRA rollover. Many people accumulate multiple 401(k)s from different jobs, and rolling them into a single IRA simplifies oversight. This makes it easier to monitor performance, rebalance asset allocation, and maintain a clear picture of retirement savings. Consolidation also streamlines beneficiary designations and simplifies taking distributions in retirement.

A rollover to a Traditional IRA can enable future tax planning strategies, specifically Roth conversions. Once funds are in a Traditional IRA, an individual can convert some or all of the balance to a Roth IRA. This requires paying income tax on the converted amount, but future growth and qualified withdrawals from the Roth IRA are tax-free. This can be a useful tool for managing taxes in retirement, especially for those who anticipate being in a higher tax bracket later.

Reasons to Keep Funds in a 401(k)

One reason to keep funds in a 401(k) is the creditor protection afforded by federal law. The Employee Retirement Income Security Act (ERISA) shields 401(k) assets from creditors in bankruptcy or lawsuits. This protection is generally unlimited and uniform across the country for plans subject to ERISA. IRA creditor protection is more complex, as outside of bankruptcy, it is governed by state laws that vary and may not be as strong as ERISA’s safeguards.

The ability to take a loan from retirement savings is a feature unique to 401(k) plans. Most plans permit participants to borrow up to 50% of their vested balance, with a maximum of $50,000. These loans must be repaid with interest back into the participant’s own account. This borrowing capability, which can serve as a source of liquidity in an emergency, is permanently forfeited if the funds are rolled over into an IRA.

A provision in the tax code known as the “Rule of 55” is an advantage for those considering early retirement. This IRS rule allows an individual who leaves their job during or after the year they turn 55 to take distributions from that employer’s 401(k) without the 10% early withdrawal penalty. This option is tied to the 401(k) and is lost if the funds are rolled into an IRA, where the penalty applies to distributions before age 59½.

Some 401(k) plans, particularly at large corporations, may offer unique or low-cost investment options not available to retail investors. These can include stable value funds or institutional-class mutual funds with very low expense ratios. In such cases, the cost savings and investment opportunities within the 401(k) may outweigh the benefits of an IRA rollover.

Special Tax and Planning Considerations

Net Unrealized Appreciation for Company Stock

A tax consideration applies to individuals holding appreciated company stock within their 401(k) through a strategy called Net Unrealized Appreciation (NUA). To use this, an employee takes a lump-sum distribution, moving the company stock “in-kind” to a taxable brokerage account while other assets can be rolled to an IRA. The employee pays ordinary income tax only on the stock’s original cost basis. The NUA, or the growth in value, is not taxed until the stock is sold, at which point it is taxed at lower long-term capital gains rates.

For example, if company stock with a cost basis of $100,000 is now worth $500,000, the NUA is $400,000. Using the NUA strategy, the owner pays ordinary income tax on the $100,000 basis and later, capital gains tax on the $400,000. If rolled into an IRA, the entire $500,000 would eventually be taxed as ordinary income upon withdrawal.

Impact on Backdoor Roth IRA Strategy

For high-income earners, a 401(k) rollover can impact the “Backdoor” Roth IRA strategy. This strategy involves making a non-deductible contribution to a Traditional IRA and then converting it to a Roth IRA. However, the IRA pro-rata rule requires that conversions consist of a proportional mix of pre-tax and after-tax dollars from all of an individual’s non-Roth IRAs.

Rolling a pre-tax 401(k) into a Traditional IRA creates a large pre-tax balance, making any subsequent Backdoor Roth conversion mostly taxable. By leaving the funds in the 401(k), the Traditional IRA balance can remain at zero, preserving a tax-free Backdoor Roth conversion process.

Required Minimum Distributions for Those Still Working

The “still working” exception is a planning opportunity for those who work past the age for Required Minimum Distributions (RMDs), currently 73. Under this exception, an individual still employed who does not own more than 5% of the company can delay RMDs from their current employer’s 401(k) until they retire.

This exception does not apply to IRAs. If funds are rolled into a Traditional IRA, RMDs must begin at age 73, even if the person is still working. Keeping money in a current employer’s 401(k) is the only way to use this deferral.