So you’ve completed your 2-week notice, cleared out your desk and bid farewell to your work colleagues……you’re changing jobs to a new firm and excited for the next chapter of what life may have in store. You’ve been with your employer for several years (which to many may seem an eternity) and have built up substantial retirement savings. While it may be a little early to retire somewhere warm and sunny and get that new Porsche you’ve been dreaming of, it’s not too far off. Ah, life is good.
But, do these hefty savings from your umpteen years at the grind have to remain your 401(k)? Not necessarily. A common option is to ‘roll’ these 401(k) funds over to an IRA (Individual Retirement Account) where your entire retirement portfolio can be consolidated under one roof. In many cases, this is the best option, but the decision to transfer retirement assets away from your previous employer’s plan to an IRA depends on several factors unique to your personal circumstances, a few of which we will touch on in this article.
By far the largest benefit of rolling over a 401(k) to an IRA are the numerous investment options available in IRA’s that are not available in 401(k)’s. 401(k) plans are restricted by law into holding more ‘standard’ investment products like equity, bond and cash-equivalent mutual funds, but not much else. As such, 401(k) account holders are often limited to 8-12 different mutual funds in these 3 asset classes. Furthermore, these funds are usually only offered by 2-3 different investment families, giving individuals further limited family fund diversification.
IRAs, on the other hand, give the investor literally a world of investment options: a universe of mutual fund and exchange traded funds (ETFs), common shares (stock) of individual companies, real estate investment trusts (REITs) and even certificates of deposit (CD’s). Furthermore, retirement assets can be spread out across fund managers that specialize in certain asset classes, for example, Cohen and Stearns in real estate and PIMCO in domestic fixed income.
Secondly, where IRA plans really shine are in the alternative investment space. Alternative investments such commodities, private equity and hedge funds (and even real estate) have become increasingly popular due to their ability to add both return and a diversification benefit to an investment portfolio. Alternative investments typically have low correlation with traditional asset classes like stocks and bonds and can therefore enhance portfolio returns while lowering overall risk and volatility. Their availability for retail investors has increased dramatically over the past 20 years, giving smaller portfolios the benefits many institutional clients have had for years.
The problem is that few 401(k) plans give investors any options as far as alternative investments are concerned. Most investment professionals would suggest holding 10-20% in alternatives investments to gain proper diversification. For example, in 2022 when stock/bond returns were so poor (down double digits), alternative investments, especially in the commodities area, produced much better returns which helped mitigate losses.
A third benefit of rolling over an old 401(k) into an IRA is the flexibility in terms of withdrawals and their tax implications. 401(k)’s can have rules that limit account holders in taking distributions: Withdrawals often have to be taken in scheduled installments, whether it be quarterly or monthly. Some plans are even more restrictive where the entire plan must be distributed immediately. IRA accounts have no such distribution limitations and therefore allow individuals the ability to manage their withdrawals and the accompanying taxes due. 401(k) plans also require a 20% Federal withholding tax on distributions, where IRA accounts have no such requirements.
On the other hand, there are several valid reasons to keep a 401(k) at your old company. The first is due to the legal protection that a 401(k) offers. The entire balance of funds held inside a 401(k) (whether you are still with your employer or not) are protected at the Federal level from most types of creditor judgements, bankruptcy proceedings and civil lawsuits. An IRA on the other hand only protects up to $1 million of assets in these types of situations (through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005). Remember that these figures are at the Federal level and your individual State may have different thresholds. As such, if you are possibly concerned about potential legal judgements, creditors or collections, holding your old 401(k) might be your best option.
Another benefit of holding retirement funds in an old 401(k) plan are the extremely low management fees that the mutual funds in most 401(k)’s charge. In a 401(k), big multinational companies with thousands of employees have agreements with mutual fund companies where they are able to invest their employee’s retirement assets through the mutual fund’s ‘institutional’ version. Institutional funds comes with significantly lower management fees and can be 0.5% lower than the fee a typical investor in an IRA can get. These higher management fees can greatly eat into investment returns, particularly over long time periods.
The third benefit of keeping a 401(k) at your old employer focuses around when you determine your retirement date to be. IRA plans charge a 10% penalty on withdrawals before the age of 59 1/2. 401(k) plans have a much earlier timeframe for penalty-free withdrawals at age 55. So if you plan on retiring earlier and want to begin withdrawals at age 55, maintaining your 401(k) where it is might be the way to go.
On the flip side, if you plan on working later in life, IRA plans have immediate withdrawal requirements that begin at age 70 ½ whether you are still working or not. This could force some individuals into a higher tax bracket and even nullify the deferred tax benefits of an IRA. If you are still working at age 70 ½ , 401(k) rules do not require employees to begin withdrawals from their current employer’s 401(k) until they cease employment. Another benefit here is that if you have rolled funds from a 401(k) from a previous employer into your current 401(k), these funds are free from taxable withdrawals at age 70 1/2 as well.