There will come a time when, prior to retirement, you’ll have a 401k plan from a former employer (sometimes referred to as an orphaned 401k) that you’ll need to figure out what to do with. You typically have three options:
- You can take a lump sum distribution.
- You can keep the money in the 401k or roll it into a new 401k.
- You can roll it into an IRA.
It’s typically not advantageous to take a lump sum distribution as you may be subject to a large tax bill and/or a penalty tax. When deciding whether to use Option 2 or Option 3, here are a few pros and cons of rolling an old 401k to an IRA versus keeping that money inside of a 401k.
The Advantages of Rolling Your 401k to an IRA
Perhaps the biggest advantage of an IRA is that a significantly greater number of investment options are available to you. With your 401k, there are ultimately a limited number of investment options that you can invest within. This can limit your ability to invest in certain asset classes or be as diversified as you may want to be. When you have your assets in an IRA, you have the opportunity to allocate your portfolio precisely how you want to.
It can also be beneficial to have your assets all located in one place. If you have old 401k plans still open, it can make it difficult for you to know precisely what your asset allocation is. If your goal is to create an effectively diversified portfolio, it’s critical you know precisely what your asset allocation is.
There’s also the advantage of flexibility that shouldn’t be overlooked. 401k plans may have limits on the number of withdrawals you can make in a given year. With an IRA, you have greater freedom in terms of deciding when to take distributions. Furthermore, first-time home buyers and those paying higher education expenses may be able to take penalty-free withdrawals from an IRA; those exemptions for early penalty-free withdrawals don’t exist for 401k plans.
Finally, you’ll also want to consider whether or not you’re looking for long-term financial planning for those assets. By rolling that money into an IRA, that may give you access to ongoing planning with a financial advisor. While there are fees associated with comprehensive financial planning, the value you may receive from that advice can more than make up for the fees that you pay.
When You Should Consider Keeping Assets in a 401k
Arguably the best reason for keeping assets in your 401k is if you’re thinking about retiring between ages 55-59.5. The reason being is that if you retire after age 55, you’ll likely be able to take a distribution from your 401k without penalty once you separate from service. If you roll those assets immediately over to an IRA, you may not be able to make any penalty-free distributions until you reach age 59.5, which could make financing an early retirement challenging.
The other option you may be considering is to work as long as possible. Keeping money in your employer’s 401k may allow you to delay taking required minimum distributions (RMDs). Normally, you’ll be mandated to take a percentage of your tax-deferred savings upon reaching age 70.5. However, if you’re currently employed, you may be exempt from RMDs on assets in your current employer’s plan, so long as you don’t have at least 5% ownership
It’s also worth looking at the expense ratios on the investments in your 401k and compare those to what similar investments may charge in an IRA. There’s been a lot of news in recent years surrounding the high fees of some 401k plans, but there are other plans that are able to negotiate lower rates because of their bargaining power. This will require a bit of research on your part, but it’s worthwhile to take the time to do so. Even saving a tenth of a percentage can make a big difference over the long term.
Finally, it’s possible that the act of moving the assets in your 401k into an IRA could produce a number of fees. It’s important that you evaluate how much in fees you may need to pay in order to make the rollover and whether or not the value you’re expecting to receive from making the rollover will outweigh the expenses. If you don’t think there’s enough value to justify the costs of the rollover, it’s probably wise to keep the assets in a 401k.
This is certainly not an exhaustive list of all the considerations that should be made when deciding what to do with an orphaned 401k plan from an old employer. Our hope is that, at the very least, this list of pros and cons will underscore the importance of planning when making an important financial decision.
This article originally appeared on April 23, 2017 in the St. Paul Pioneer Press. You may view the article here.
Bruce Helmer, a founding member of Wealth Enhancement Group, has been the host of the “Your Money” Radio Show for more than 20 years. He is also featured weekly on the Twin Cities CBS affiliate WCCO, and has penned three financial advice publications.