Archives for January 2020

Get new articles by email:

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning.

Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

401k Rollover: Where, Why, and How

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

After leaving your job, you’ll have to decide whether or not you want to roll your 401(k) into an IRA.

Comparing Investment Options

Reducing your investment costs is one of the most reliable ways to improve your investment returns. Some employer-sponsored plans offer a satisfactory lineup of low-cost choices. For example, federal employees with access to the Thrift Savings Plan can build an extremely low-cost diversified portfolio without needing to take their money anywhere else.

Many 401(k) plans, however, do not provide their participants with low-cost options. If that’s the case with your employer’s plan, that’s a strong point in favor of rolling the money into an IRA, where you’ll have access to a wide array of low-cost investment options in every asset class.

Lower Fees in an IRA

In addition to potentially limiting you to high-cost funds, some 401(k) plans include administrative fees, whereas it’s easy to find brokerage firms that will charge no annual IRA fees at all.

Between less expensive investment options and lower administrative costs, you may be able to reduce your total investment costs by 0.5% per year (or even more, in some cases) simply by moving your money from a 401(k) to an IRA. That might not sound like much, but when compounded over your whole retirement, improving your investment return by 0.5% can have a significant impact on how long your money lasts.

Roth 401(k) Rollover to Avoid RMDs

If you have a Roth 401(k) account, there is an additional point in favor of rolling it over (into a Roth IRA). Specifically, after you reach age 72 (age 70½ for anybody born before July 1, 1949) you will have to start taking required minimum distributions each year from your Roth 401(k). In contrast, Roth IRAs do not have required distributions while the owner is still alive. So by rolling your Roth 401(k) to a Roth IRA, you can avoid having to deal with RMDs during your lifetime.

Reasons Not to Roll Over a 401(k)

There are, however, a few specific situations in which it doesn’t make sense to roll over a 401(k)—or other employer-sponsored retirement plan—after leaving your job.

Retiring Early?
If you are “separated from service” (i.e., you leave your job, were laid off, etc.) in a calendar year in which you turn age 55 or older, distributions from your 401(k) with that employer will not be subject to the 10% additional tax that normally comes with retirement account distributions before age 59½.

As a result, if you are 55 or older when you leave your job (or you will turn 55 later that year) and you plan to retire prior to age 59½, it may make sense to put off rolling your 401(k) into an IRA until you are 59½. This way, if you need to spend some of the money prior to age 59½, you can do so without having to worry about the 10% additional tax.

Planning a Roth Conversion?
Alternatively, if you currently have a traditional IRA to which you made nondeductible contributions and you are planning a Roth conversion, you may want to hold off on rolling over your 401(k) until the year after you’ve executed the Roth conversion, so as to minimize the portion of the conversion that’s taxable.

Does Your 401(k) Include Employer Stock?
Lastly, if your 401(k) includes employer stock that has significantly appreciated in value from the time you purchased it, you’d do well to speak with an accountant before rolling over your 401(k) or taking distributions from the account. Why? Because under the “net unrealized appreciation” rules, you may be able to take a lump-sum distribution of your 401(k) account, moving the employer stock into a taxable account and rolling the rest of the account into an IRA.

Why would such a maneuver be beneficial? Because, if you roll the stock into a taxable account, only your basis in the stock (i.e., the amount you paid for it) will be taxed as a distribution. The amount by which the shares have appreciated in value (the “net unrealized appreciation”) isn’t taxed until you sell the stock. And even then, it will be taxed at long-term capital gain tax rates (currently, a max of 20%) instead of being taxed as ordinary income.

In contrast, if you roll the stock into an IRA, when you withdraw the money from the IRA, the entire amount will count as ordinary income and will be taxed according to your ordinary income tax rate at the time of withdrawal.

EXAMPLE: Martha recently retired from her job with a utility company. She owns employer stock in her 401(k). The stock is currently worth $100,000. Her total cost basis for the shares is $42,000.

If she rolls her entire 401(k) into an IRA, when she withdraws that $100,000, the entire amount will be taxable as ordinary income.

If, however, she rolls the employer stock into a taxable account, she’ll only be taxed upon her basis in the shares ($42,000). And when she eventually sells the shares, the gain will be taxed as a long-term capital gain (at a maximum rate of 20%) rather than as ordinary income.

Remember, though, that holding a significant amount of your net worth in one company’s stock is risky—especially when that company is your employer. Be careful not to take on too much risk in your 401(k) solely in the hope of getting a tax benefit in the future.

And to reiterate, if you think you might benefit from the net unrealized appreciation rules, it’s definitely a good idea to speak with a tax professional to ensure that you execute the procedure properly.

How to Roll Over a 401(k)

In most cases, rolling over a 401(k) is just four easy steps:

  1. Open a traditional IRA if you don’t already have one,
  2. Request rollover paperwork from your plan administrator,
  3. Fill out the paperwork and send it back in, and
  4. Once the money has arrived in your IRA, go ahead and invest it as you see fit.

When you’re filling out the paperwork, you’ll want to initiate a “direct rollover.” That is, do not have the check made out to you. Have it made out to—and sent to—the new brokerage firm.

If for some reason the check arrives in your own mailbox, don’t panic. But be sure to forward the check to the new brokerage firm ASAP. If you don’t get it rolled over into your new IRA within 60 days, you will (in most cases) lose the ability to roll it over, and the entire amount will count as a taxable distribution this year.

Where to Roll Over Your 401(k)

In terms of where to roll over your 401(k), you have three major options. You can roll your 401(k) account into an IRA at:

  1. A mutual fund company,
  2. A discount brokerage firm, or
  3. A full service brokerage firm.

Rolling a 401(k) into an IRA with a mutual fund company can be a good choice. As long as you make sure to choose a fund company that has low-cost funds, low (or no) administrative fees for IRAs, and a broad enough selection of funds to build a diversified portfolio, you should do just fine. For example, Vanguard and Fidelity have excellent index funds and would be great places to roll over a 401(k).

Your second option is to roll your 401(k) account into an IRA at a discount brokerage firm, such as E*TRADE. Due to the proliferation of exchange-traded funds (ETFs), you can now quickly and easily create a low-cost, diversified portfolio at any discount brokerage firm.

Option #3—using a full service brokerage firm (e.g., Edward Jones)—is one I’d generally recommend against. At these companies, financial advisors will usually try to sell you a portfolio of funds with front-end commissions (a needless cost) or an advisory account with unnecessarily high ongoing fees.

Simple Summary

  • Rolling your 401(k) into an IRA after leaving your job may give you access to better investment options and/or reduce your administrative costs.
  • If you left your job at age 55 or older (or in the year in which you turn age 55), and you plan to retire prior to age 59½, you may want to postpone rolling over your 401(k) until you reach age 59½.
  • If you’re planning a Roth conversion of nondeductible IRA contributions, you may want to hold off on a 401(k) rollover until the year after your Roth conversion.
  • If you have employer stock in your 401(k), before rolling your 401(k) into an IRA, it’s probably a good idea to speak with an accountant to see if you can take advantage of the net unrealized appreciation rules.
  • In most cases, the best place to roll over a 401(k) is a mutual fund company with low-cost funds or a discount brokerage firm that offers low-cost (or no-cost) trades on ETFs.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Asset Allocation and Risk Tolerance

The following is an adapted excerpt from my book Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less.

When putting together a portfolio, the first thing to decide is your desired asset allocation. That is, how much of your portfolio should be invested in each asset class (e.g., U.S. stocks, international stocks, and bonds)?

Your tolerance for risk is the most important factor in determining an appropriate asset allocation. The primary factors determining your risk tolerance are:

  1. Your economic/financial ability to tolerate risk (i.e., how much risk you can afford), and
  2. Your emotional/psychological ability to tolerate risk.

Your economic ability to handle risk is significantly impacted by the degree of flexibility you have with regard to your financial goals.

Financial Flexibility

Example 1: Jason is a construction worker. He’s 57, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered — but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.

Example 2: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $80,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $80,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a greater ability to take risk.

Comfort with Volatility

Your risk tolerance is also affected by your comfort level with volatility. One way to estimate this comfort level is to ask yourself, “How far could my portfolio fall before I started losing sleep, feeling stressed, or wanting to sell everything and move to cash?”

When answering this question, be sure to answer both as a percentage and as a dollar value — otherwise you may come to inaccurate conclusions. For example, you may remember that at age 25 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 10-times the size that it was at age 25, a 40% loss could be an entirely different experience.

When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative for your tastes, you’ll only be missing out on a relatively small incremental return.

In contrast, if you end up with a portfolio that’s too aggressive, you might end up panicking during periods of high volatility. Even one instance of getting out of the market after a sharp decline can be more than enough to eliminate the extra return you were hoping to earn from having a stock-heavy allocation.

Stocks vs. Bonds

Once you have an idea of your risk tolerance level, it’s time to move on to the first (and most important) part of the asset allocation decision: your stock/bond allocation.

One rule of thumb that serves as a reasonable starting point for analysis is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, said differently, assume that your stocks can lose 50% of their value at any time.

The most important thing to remember with asset allocation guidelines, however, is that they’re just that: guidelines. For example, with regard to this particular rule of thumb, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

U.S. Stocks vs. International Stocks

As you might imagine, the U.S. stock market isn’t the best performing market in the world every single year. In fact, it’s often not in the top 10.

The difficulty in international investing — as with picking stocks or actively managed mutual funds — is that it’s nearly impossible to know ahead of time which countries are going to have the best market performance over a given time period. The solution? Own all (or at least many) of them.

The primary goal of investing a portion of your portfolio internationally should not be to increase returns, as there is no guarantee that international markets will outperform our own. Rather, the primary goal is to increase the diversification of your portfolio, thereby reducing your risk.

In total, the U.S. stock market makes up roughly half of the value of all of the publicly traded stocks in the world. However, for two reasons, most investment professionals recommend allocating more than 50% of the stock portion of your portfolio to domestic equities. First, international funds generally have somewhat higher expense ratios than domestic funds. Second, investing internationally introduces an additional type of risk into your portfolio: currency risk.

Currency risk is the risk that your return from investing in international stocks will be reduced as a result of the U.S. dollar increasing in value relative to the value of the currencies of the countries in which you have invested.

EXAMPLE: A portion of your portfolio is invested in Japanese stocks, and over the next year it earns an annual return of 8%. However, over that same period, the value of the yen relative to the dollar decreases by 3%. Your annual return (as measured in dollars) would only be roughly 5%.

So how much of your portfolio should be invested internationally? There’s a great deal of debate on this issue, with investment professionals recommending a very wide range of international allocations.

Without knowing how the U.S. market will perform in comparison to markets abroad, there’s simply no way to know what the “best” allocation will be. In my own opinion, there’s a pretty broad range that’s reasonable. Allocating anywhere from 20% to 40% of the stock portion of your portfolio to international index funds would be reasonable for most investors—with the general idea being to give international stocks a somewhat smaller weighting than their (roughly) 50% market weight (due to their higher costs and currency risk), while still making sure that the international allocation is of sufficient size for it to offer a meaningful diversification benefit.

Rebalancing

No matter how perfectly you craft your portfolio, there’s little doubt that in not too terribly long, your asset allocation will be out of whack. The stock market will have either shot upward, thereby causing your stock allocation to be higher than intended, or it will have experienced a downturn, causing your stock allocation to be lower than intended.

Rebalancing is the act of adjusting your holdings to bring them back in line with your ideal asset allocation. A periodic rebalancing program helps keep the risk level of your portfolio in line with your goals.

How often should an investor rebalance? That’s a tricky question. Some people advocate in favor of rebalancing once your portfolio is off balance by a certain amount (such as your stock allocation being either 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals (annually on your birthday for instance) regardless of how off-balance your portfolio becomes in the interim.

The best-performing rebalancing strategy varies from period to period, and it’s no easy task to predict which one will do best over the course of your investing career. Rather than spending a great deal of time and effort thinking about it, my suggestion is simply to pick one method and resolve to stick with it.

It’s worth noting that rebalancing can be quite difficult emotionally/psychologically. It can feel as if you’re selling your “good investments” to put money into your “bad investments.” The key is to remember that just because something has performed well (or poorly) recently doesn’t mean that it will continue to do so in the immediate future.

Simple Summary

  • Your tolerance for risk should be the primary determinant of your stock/bond allocation. Your risk tolerance is determined by how much risk you can afford and how much risk you can tolerate psychologically.
  • Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.
  • For the sake of additional diversification, most investment professionals recommend investing somewhere from 20% to 40% of your stock holdings internationally.
  • Rebalancing is the act of bringing your portfolio back to its targeted asset allocation (and, therefore, its targeted risk level).
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a registered investment advisor or representative thereof, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2021 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security