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How Often to Rebalance a Portfolio

A reader writes in, asking:

“We are getting closer to retirement and beginning to adjust our asset allocation. Recently we rebalanced our asset allocation from 90/10 stocks/bonds to 70/30. It was the first time we rebalanced in about 7 years. We think given our time horizon we should consider 50/50 or even 40/60. It’s a very difficult decision.

In addition, we’re trying to figure out how often we should be rebalancing going forward as we move into retirement.

How do we figure out what is the best rebalancing frequency for our funds held at Vanguard: Total Stock Market Index Fund, Total Bond Market Index Fund and Intermediate Term Bond Index Fund? Those funds are our complete retirement portfolio…trying to make you proud…KISS. You helped us so much in the 10+ years that we have been following you.”

First a note on terminology, because it may cause some misunderstandings when reading the links I’m about to provide: the change that you describe having recently made is not rebalancing. Rebalancing is when you bring your allocation back to the intended (target) allocation. For example, if the target is a static 60/40 allocation and every quarter you make adjustments to bring the portfolio back to the 60/40 allocation, that’s rebalancing. If you change the target (e.g., deciding instead that a 40/60 allocation is the new target), that’s not rebalancing.

This is not to say that changing the target is a bad idea. Sometimes it’s a good idea — especially as your life circumstances change. I’m just belaboring this terminology point, because when reading about rebalancing in more technical writing, it’s important to know very specifically what is being discussed. (This is a common terminology mix-up, by the way. People get it wrong constantly on the Bogleheads forum for instance.)

And with that out of the way, the following are a few things you may want to read.

A takeaway from reading the three articles above is that rebalancing more often than annually is likely not a great idea. In very brief, the reason is that the stock market has historically exhibited a slight degree of momentum over periods shorter than a year. That is, if yesterday was a good day, today is more likely than usual to be a good day. And if yesterday was a bad day, today is more likely than usual to be a bad day. And the same goes for monthly periods.

And the result is that rebalancing daily or monthly would mean that, in a market downturn, you’re constantly buying more stocks as they keep falling, resulting in an overall loss that’s worse than if you hadn’t been rebalancing. And during upward markets, you’re constantly selling stocks, resulting in less of a gain than if you hadn’t been rebalancing.

The following two links are runs from PortfolioVisualizer, comparing monthly vs annual rebalancing, for a basic 3-fund portfolio using a “4% rule” spending strategy. Rebalancing annually worked out slightly better in terms of return, maximum drawdown, and standard deviation. (Note that I’m simply using the earliest start date available here, and letting it ride until today. If interested, you could instead test with rolling 30-year periods, for instance, to see how reliable this outcome is. You could also test with different target allocations or with different spending strategies.)

Plot Twist: Contrary Evidence

There’s also, however, a 2010 paper from Vanguard (no longer on their website, but here’s a Web Archive link), which found essentially no difference between rebalancing monthly, quarterly, or annually — other than the time (and potentially transaction costs) involved in doing so.

Also, as always, anything based on historical data — as all of the above is — should be treated with a healthy degree of skepticism. Sometimes, trends that persisted for a very long period, even many decades, eventually disappear, as the markets themselves change (e.g., as the participants in the market shift, as products available change, as laws/regulations change, etc.)

And indeed, per a 2022 paper, it appears that that’s exactly what has happened:

In this paper, the author found that the autocorrelation of stock returns (i.e., the correlation from yesterday’s returns to today’s returns) declined over the period 1960-2019 and actually became significantly negative in the second half of the sample. That is, yesterday being a good day would mean today is more likely than usual to be a bad day, and vice versa. And that would mean that rebalancing everyday (as you would see in a target-date or LifeStrategy fund) would actually be helpful.

So, where does all of this leave us?

Frankly, I really don’t know, other than to say that there’s some good evidence in favor of just about any option. My personal thinking at this point can be summarized as follows:

  • If you have a target-date fund, LifeStrategy fund, or anything similar which is rebalancing for you daily, that’s probably fine. (Though it can create tax costs in a taxable account.)
  • If you’re using a DIY allocation, and you want to rebalance quarterly, annually, or every two years (or “annually but only if the allocation is off-target by at least x%”), that’s probably fine too.
  • More frequent rebalancing means more work, if you’re doing the rebalancing yourself.
  • I wouldn’t worry too much about this topic overall. Nor would I put too much faith in Strategy A instead of Strategy B. It’s more along the lines of “pick one approach that seems reasonable, and stick with it.”

Retiring Soon? Pick Up a Copy of My Book:

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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.

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What’s Your Funded Ratio?

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

In a recent episode of the Bogleheads on Investing podcast, I mentioned the idea of calculating a funded ratio — and how that can be more useful than “4% rule” -style guidelines, especially when a household’s level of non-portfolio income will be changing materially at various points through retirement.

I received several email questions from people asking for more information about that topic.

One limitation of “safe withdrawal rate” rules of thumb is that they assume that the amount you have to spend from the portfolio does not change from one year to the next (other than due to inflation). In real life, however, most households find that the amount they must spend from the portfolio does change significantly at various points in time, as their level of income from non-portfolio sources changes.

EXAMPLE: Raman (age 55) and Nisha (age 57) are married and both are still working. Raman plans to retire at age 60 (5 years from now), and Nisha plans to retire at age 65 (8 years from now). They each plan to file for Social Security at age 70.

When Raman retires, they’ll initially have to spend about 3% from their portfolio each year to cover their expenses. When Nisha retires, they project that their spending rate will go up to about 7% of the portfolio balance each year. When Nisha’s Social Security kicks in, their spending rate will fall back to about 5%, and when Raman’s kicks in it will fall to around 2%.

Based on guidance like the 4% rule, it’s hard to tell if Raman and Nisha’s plan is safe (because they’ll be spending less than 4% most years) or unsafe (because they’ll be spending considerably more than 4% for some years early in retirement).

Guidelines like the 4% rule simply can’t account for such situations very well. And for some households there could be even more stages to account for, if either person has a pension or is planning on a “phased” retirement in which they scale back work gradually.

Calculating your “funded ratio” is one way to get a sense of your retirement preparedness, when you anticipate that your amount of non-portfolio income will change from one year to the next.

What’s a Funded Ratio?

Your funded ratio is the sum of your current portfolio value and all of your future non-portfolio income, divided by the sum of all of your future expenses.

Or more precisely, it’s the sum of your current portfolio value and the present value of all of your future non-portfolio income, divided by the present value of all of your future expenses. The point of this “present value” wording is simply to account for the fact that dollars in the future are less valuable than dollars today. For instance, if you received $1,000 of income today, you could use that sum to pay for more than $1,000 of expenses 20 years from now, because you could invest the money between now and then. (See this article for a more thorough explanation of the present value concept.)

Said yet another way, your funded ratio is the ratio of your income and assets to future liabilities, if we assume that the assets will grow at a conservative interest rate.

Funded ratios are often expressed as a percentage. If your funded ratio is at least 100%, that indicates that your portfolio and future income should be enough to cover your future expenses. A funded ratio of less than 100% indicates that something in the plan should be changed (e.g., working longer, thereby increasing the sum of your future income, or cutting expenses).

A Simple Funded Ratio Example

Below you can find a spreadsheet that gives a simple example of a funded ratio calculation:
https://obliviousinvestor.com/FundedRatio.xlsx

Note that in the example spreadsheet, I have lumped income all into one column and expenses all into one column. You may prefer instead to separate them out by source (e.g., a column for work income, a column for Social Security, etc.).

Funded Ratio Caveats

There are a few caveats to keep in mind when calculating your funded ratio.

Firstly, it’s critical to use a conservative discount rate. The discount rate can be thought of as the rate of return that the portfolio will earn. And there is no uncertainty reflected. In other words, we’re assuming that the portfolio will earn this rate of return every year, without fail. So if you choose an aggressive discount rate (such as the return you’d expect from a portfolio with a considerable stock allocation), you’re setting yourself up for failure if your portfolio happens to earn a lesser return. Hence, the expected return from very safe assets should be used.

Second, in addition to being sensitive to the discount rate input, a funded ratio calculation is sensitive to the planning horizon input. That is, it’s up to you to make an assumption about how long you’ll need your savings to last. Picking a shorter planning horizon can make your funded ratio look much better — and can again set yourself up for failure, if you live beyond that point.

Finally, I don’t think that a funded ratio calculation should be the only type of retirement-preparedness analysis that you do. Additional tests with Monte Carlo simulations (or potentially historical simulations) can be informative as well.

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."

What is a Qualifying Longevity Annuity Contract (QLAC), and Who Should Buy One?

A reader writes in, asking:

“I have a question about changes to QLACs made in SECURE 2.0. The question is, do any of the changes make them more attractive in some cases? If so, what would be the general criteria for using a QLAC? Suppose you are in the fortunate position of not needing IRA funds in early retirement. Would the costs and risks of a QLAC, now updated by SECURE 2.0, be outweighed by the advantages of deferring taxes until age 85?”

First let’s go back over the basic information here: what’s a QLAC? Then we’ll discuss for whom a QLAC might make sense — and whether/how that has changed as a result of the SECURE Act 2.0 that was passed in late 2022.

A “qualifying longevity annuity contract” (QLAC) is a special tax treatment that can be given to a deferred annuity if it meets various requirements and if it is purchased inside a traditional IRA or tax-deferred employer-sponsored retirement plan, such as a 401(k).

Deferred Lifetime Annuities in General

A basic deferred lifetime annuity works like this:

  • You pay a lump sum premium now (e.g., at age 65) to an insurance company, then
  • Starting at a specific age in the future (e.g., age 85) the insurance company begins paying you a specific amount of money every month, and they continue to do so for the rest of your life.

In other words, these are much like immediate lifetime annuities, except for the fact that the income doesn’t kick in for many years (hence, “deferred lifetime annuity”). And, because the payments don’t kick in for several years, the premium is much lower for a given level of income.

For example, as of this writing, for a 65-year-old female to purchase an immediate lifetime annuity paying $1,000 per month, the premium would be $169,731. In contrast, for a 65-year-old female to purchase a deferred lifetime annuity, for which payments begin at age 85, paying $1,000 per month, the premium would be $24,480. (These quotes are coming from ImmediateAnnuities.com.)

QLAC Tax Treatment

Generally, with a traditional IRA or 401(k), you have to start taking required minimum distributions (RMDs) upon reaching age 73 or 75, depending on your year of birth. Without special tax treatment, buying a deferred lifetime annuity that pays nothing until, say, age 80, could cause a problem if you were to buy that annuity within a traditional IRA. The annuity is not liquid, so you might end up in a situation in which the liquid IRA balance is not sufficient to satisfy your RMD.

The special QLAC tax treatment eliminates this as a potential problem. As long as the annuity meets the requirements to be a qualifying longevity annuity contract, the value of the annuity is not included in the value of your IRA — or 401(k) or other similar account — when calculating your RMD.

Requirements to be a QLAC

A deferred annuity must meet several requirements to be considered a QLAC.

First, payments must start no later than the first day of the month after the month in which you reach age 85.

Second, the annuity must not be a variable annuity or “indexed annuity” (i.e., equity indexed annuity/fixed index annuity).

Third, the annuity cannot have much in the way of bells and whistles. Optional riders that would be allowed include:

  • Inflation adjustments,
  • Survivor benefits to a designated beneficiary, provided they meet a few specific requirements (e.g., in most cases the benefit to the survivor cannot be greater than the payments that were being made to the original owner), and
  • A “return of premium” rider, wherein upon the death of the original owner, the designated beneficiary receives an amount equal to the premium(s) paid, minus any amount that has been paid out so far.

Finally, the total premium(s) paid for your QLAC(s) must not exceed $200,000.

What Was Changed by the SECURE Act 2.0?

Prior to the SECURE Act 2.0, the dollar limitation was lower, and the QLAC was not allowed to exceed 25% of your IRA or 401(k) balances.

In short, the changes made it so that people can buy bigger QLACs. But the changes didn’t make QLACs any more appealing. If a QLAC didn’t make sense for a given household before, it probably still doesn’t make sense now.

And in fact, if a QLAC is seen as a tool for delaying RMDs, then the SECURE Act 2.0 actually made QLACs slightly less useful, because it was that same piece of legislation that pushed the RMD age back to begin with. (That is, prior to the SECURE Act 2.0, the RMD age was 72. So QLACs effectively let you defer RMDs from 72 to 85, which is 13 years of deferral. Now, with the RMD age being 73 or 75, delaying to age 85 is fewer years of deferral.)

Who Should Buy a QLAC?

There are basically two sides to this decision:

  1. Does the household want a deferred lifetime annuity? (That is, ignoring the tax treatment, do they want an annuity of this nature in the first place?)
  2. Would the QLAC tax treatment be beneficial?

With regard to the first point, the value of such annuities is that they provide longevity protection at a lower cost than immediate lifetime annuities. So they’re most likely to be useful to a household that is concerned about longevity risk (i.e., in good health, and likely in that grey zone of “do we have enough?”).

But, at least in my view, the big problem with these contracts themselves is the inflation risk. To the best of my knowledge, no insurers offer QLACs with an inflation adjustment that begins at the time of purchase. (And from reading the applicable Treasury Regulation, I’m not entirely confident that such would even be allowed.) Rather, if a cost-of-living adjustment is provided, the adjustments begin when the payments begin. So the household is “on the hook” for any inflation that occurs between the time of purchase and the time the annuity payments begin.

Depending on when you buy the QLAC and when you have the payments start, that could be decades of inflation, which leaves a significant possibility that the income you ultimately receive is worth much less than you anticipated.

So when trying to determine who is the ideal candidate for a QLAC, we’re looking for a household that is concerned about longevity risk but not concerned about inflation. Frankly, I don’t really know who that would be.

As far as the tax treatment, for many households, the value of delaying RMDs from tax-deferred accounts until age 85 isn’t that valuable because they would be spending their full RMDs anyway. And that’s especially likely to be true for the households that are most exposed to the risk of portfolio depletion in long-life scenarios. In other words, the households most exposed to longevity risk (i.e., the households for whom a deferred lifetime annuity is most likely to be attractive) are the households for whom the deferral of RMDs (i.e., the unique tax planning feature of a QLAC) is least likely to be valuable.

In addition, for a married couple, if the tax planning goal of a QLAC is just to push income later into life, it’s worth noting that doing so also has the effect of pushing a greater portion of the income into the “single” filing status years instead of the “married filing jointly” years, which likely increases the applicable tax rate — though the size of survivor benefit selected for the annuity would be an important factor here.

So the ideal candidate for a QLAC is a household that is concerned about longevity risk (i.e., they’re in good health and concerned about portfolio depletion in a long-life scenario), yet they’re anticipating spending less than their RMD every year and are not concerned about inflation risk. It’s hard to think of a set of life and financial circumstances that would cause a household to be in such a position.

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."

Social Security and Safe Spending Rates

A reader writes in, asking

“I’m a big fan of Morningstar and the stuff they’ve released recently on ‘safe withdrawal rates.’ My question is how I should be thinking about future Social Security payments, when I calculate my ‘safe withdrawal rate.’

To me, it makes sense to add the NPV (calculated conservatively) of the future Social Security payments that I expect my wife and I to receive to our current portfolio, before I do the math on what our starting annual withdrawal number looks like.

Have you published anything on how to think about that question?”

That’s a great question, and it gets directly to the limitations of safe spending rate research. That is, such research is very helpful for determining approximately how much a person should have saved before retiring, but when trying to use it as an actual spending plan, it comes up somewhat short.

The biggest issue isn’t that the strategy of spending a fixed (inflation-adjusted) amount from the portfolio every year is necessarily a bad strategy (though it does have some drawbacks). Rather, the issue is that such an idea is simply not applicable for most real-life households.

That is, in most households, it’s rare that (inflation-adjusted) spending from the portfolio will be kept constant from one year to the next, because the amount of non-portfolio income changes meaningfully over time — for example as the person semi-retires, then fully retires, then Social Security begins. And for a couple, there are even more distinct phases, because there are twice as many retirement dates and twice as many Social Security start dates.

As far as considering the expected present value of your lifetime Social Security benefit to be a part of the portfolio, and then calculating an initial spending amount accordingly, the issue I see with that is that it depends significantly on what real interest rates are at the time of the calculation. And the higher that real interest rates are (i.e., the higher the discount rate used in the PV calculation), the lower the PV will be, which would indicate spending a lower dollar amount. And that’s rather backwards (i.e., higher real interest rates should indicate that you can spend at a higher rate).

My preferred way to incorporate Social Security into the analysis is to consider it a reduction in spending, for the years in question.

You can do this manually. Calculate what your non-portfolio income will be, year-by-year (including Social Security, earned income, and anything else). Then you can carve out a piece of the portfolio to “replace” that income in the years in which it won’t exist. And then you can spend at a fixed (inflation-adjusted) rate from the rest of the portfolio. (In the context of Social Security, this is often referred to as creating a “Social Security bridge.”)

Very basic example: Bob is single. He’s 65, just retired. He plans to file for Social Security at age 70, at which point he’ll get $36,000 per year. He could allocate 5 x $36,000 = $180,000 to something safe (e.g., a short-term bond fund or a 5-year CD ladder). And he could spend from that chunk of money at a rate of $36,000 per year. And he would spend from the rest of his portfolio at a fixed (inflation-adjusted) rate, which would lead to a fixed (inflation-adjusted) total spending rate also.

As mentioned above though, a real implementation of this idea is likely to be more complicated than this simple example, because there may be a phased retirement — or perhaps a pension or annuity that starts on some particular future date. And there may be two people involved, which would mean even more dates at which the level of non-portfolio income will shift.

Also, ideally, the above calculation would be done on an after-tax basis.

And, admittedly, all of that can get rather cumbersome when taking a DIY approach.

If you want, you can use financial planning software for this, because it can do all of this math (including the taxes) very quickly. The software I use for retirement spending analysis is RightCapital. It’s great, but it’s priced for advisors. The only reason I mention it is that, because I’m happy with the software that I’m using, I’m not also spending time test-driving a whole bunch of other software packages. So I can’t confidently recommend one software package or another for individual users. I have heard good things about the following, but I have not tested them myself.

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."

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.

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.

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Pension Choices: Lump Sum or Monthly Payment?

A reader writes in, asking:

“The age old question: Lump Sum or Monthly Payment? A few years ago it was considered lunacy in the office for anyone who took the Monthly vs Lump option. With increasing interest rates the Lump option today is significantly smaller than last year – and stability of guaranteed income the Monthly is looking more attractive in today’s climate. How does someone figure out – optimal choice, not just Lump vs Monthly, but, if you go Monthly understanding the financial tradeoff on choices of survivor percentage, to “X year Certain and Life Annuity” and “Cash Refund Unpaid Balance” payment options. How do you figure out what is the better option – or at least what you are trading off on one vs the other?”

For pension decisions, when looking at the decision for a client, I typically take two approaches.

First is the quick/easy approach, which is to compare via an online annuity quote provider, such as immediateannuities.com. I’ll put in a given premium (e.g., $100,000), and see what is the annual percentage payout available, for a person who is the age in question (or for a couple of the applicable ages).

And then that percentage payout can be compared to the percentage that is available as the pension annuity option (i.e., annual income, divided by alternative lump sum). Sometimes what you’ll see is that, relative to what’s available in the private marketplace, the pension annuity option is a very good deal or a very bad deal, which then makes the decision relatively easy. Often though, the answer is that it’s a roughly “fair” deal.

And I’ll repeat that process for each pension option for which there is a comparable annuity option. Sometimes you’ll find that one of them is clearly the best deal, actuarially. One limitation of the above method though is that there are often a broader range of pension payout options (especially survivor options) than comparable options on annuity websites.

The second approach is to do an expected present value comparison. For a single person, that’s essentially asking what is the person’s life expectancy, and then “discounting” those expected payments (from the lifetime annuity option) to determine the present value, and see whether that is meaningfully higher or lower than the amount available from the lump sum. (This article has steps for doing a present value calculation in Excel.)

For a married couple, it’s the same general concept but a bit more involved. In that case, I use this spreadsheet (credit to #Cruncher on the Bogleheads forum) to calculate how likely each of the mortality scenarios is for each year going forward (i.e., probability both people are alive, probability only personA alive, probability only personB is alive, probability neither person is alive). And then for each year I multiply those probabilities by the benefit payment in question (i.e., payment if both people are alive, payment if only personA is alive, and payment if only personB is alive). And then I discount all of those probability-weighted cash flows back to their present value, and see how that compares to the lump sum option.

When doing an analysis similar to the above, it’s important to use varying mortality assumptions to see how sensitive the results are to such changes. And the results should be treated as a rough conclusion, because we don’t know how long you (and/or your spouse, if applicable) will live. So, for example, if two options are only a few percentage points apart in terms of expected present value, rather than concluding, “ah, this option is better,” I think a more appropriate conclusion is, “these two options are very similar.”

In addition, all of the above is purely dealing with the actuarial expected payout. And there are two other factors to consider as well: taxes and longevity risk.

With the Social Security filing decision, tax planning is usually a point in favor of waiting (because Social Security benefits are themselves tax-advantaged). But with the pension decision, it could point in either direction, or neither.

From a longevity risk point of view, the annuity option (if married, the annuity option with the highest survivor benefit) is generally the better option, though as per the above discussion it could make sense to take the lump sum and buy an annuity elsewhere. In addition, for people whose desired retirement spending is very modest relative to available resources, longevity risk is already very low. So a further reduction in that risk isn’t particularly valuable.

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."
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