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.