What Are the Disadvantages of Rolling Over a 401k to an IRA?

A 401(k) to IRA rollover involves moving retirement savings from a former employer’s plan into an Individual Retirement Account you control. This is a frequent financial decision after a job change, but rollovers are not always the best option. It is important to understand the potential downsides and the benefits that are permanently forfeited. In some cases, leaving funds in a former employer’s 401(k) or moving them to a new employer’s plan may be a more suitable choice.

Forfeiture of 401(k) Withdrawal and Loan Options

One disadvantage of a 401(k) rollover is losing access to plan-specific liquidity options. Many 401(k) plans allow participants to borrow against their savings, typically up to 50% of the vested balance with a $50,000 maximum. The interest paid on the loan goes back into your account. Once you roll funds into an IRA, this loan capability is permanently lost. IRAs are prohibited by law from offering loans, and any attempt to borrow is a prohibited transaction with severe tax consequences.

Another benefit forfeited is the “Rule of 55.” This IRS provision allows someone who leaves a job in or after the year they turn 55 to take distributions from that 401(k) without the 10% early withdrawal penalty. While income tax still applies, avoiding the penalty is an advantage for early retirees. This exception does not apply to IRAs. Rolling over the funds means any withdrawals before age 59½ would be subject to the penalty, so keeping funds in the 401(k) is necessary to preserve this option.

Reduced Asset Protection and Potentially Higher Fees

A 401(k) rollover changes how your retirement assets are protected from creditors. Funds in a 401(k) are governed by the Employee Retirement Income Security Act of 1974 (ERISA). ERISA provides a federal shield that protects retirement savings from creditor claims during a lawsuit or bankruptcy, and this protection is generally unlimited.

When you roll funds into an IRA, you lose ERISA’s protection. The level of protection for an IRA becomes more complex and is determined by individual state laws for creditor claims outside of bankruptcy. These state laws vary widely and may be less generous than the federal guarantee provided by ERISA. In federal bankruptcy, funds rolled over from a 401(k) into an IRA are generally provided with unlimited protection.

A rollover can also lead to higher investment costs. Large 401(k) plans often have access to institutional-class mutual funds, which feature lower expense ratios than the retail-class funds available in an IRA. This difference in annual fees can compound over time and significantly reduce long-term returns, even if invested in the same fund.

Studies show the median expense ratio for retail shares in an IRA can be 37% to 56% higher than for institutional shares in a 401(k). As an example, a young worker rolling over $30,000 could lose tens of thousands of dollars over 40 years due to higher IRA fees. Some IRAs may also charge separate account maintenance, advisory, or trading fees not found in many 401(k) plans.

Significant Tax-Related Drawbacks

A 401(k) rollover can eliminate a tax strategy for company stock called Net Unrealized Appreciation (NUA). NUA is the difference between the original cost of company stock in your 401(k) and its current market value. For highly appreciated company stock, NUA rules allow for tax savings, but only if you do not roll the stock into an IRA.

To use the NUA strategy, you must take a lump-sum distribution of your entire 401(k) account within one calendar year after leaving your employer. The company stock is transferred to a taxable brokerage account, while other assets can be rolled into an IRA. You then pay ordinary income tax only on the stock’s original cost. The NUA is not taxed until you sell the shares, at which point it is taxed at lower long-term capital gains rates.

A rollover to a traditional IRA can also complicate the “backdoor Roth IRA” strategy used by high-income earners. This strategy involves making non-deductible contributions to a traditional IRA and converting them to a Roth IRA to bypass income limits. The process is most effective when you have no other pre-tax money in any traditional, SEP, or SIMPLE IRAs.

A 401(k) rollover introduces a large pre-tax balance into your traditional IRAs. This triggers the IRS pro-rata rule for any subsequent Roth conversions. This rule requires a conversion to be treated as a proportional mix of pre-tax and after-tax funds from all your aggregated IRAs, making a large portion of the conversion taxable.