Bad Advice on 401(k) Rollovers Could Cost You a Quick $85,000 or More
How to decide whether to leave retirement accounts at past employers, and roll over your funds safely and profitably
There’s about $7 trillion sitting in 401(k)s and other defined contribution retirement accounts. And a good chunk of that is eligible to be moved out of a company-sponsored plan. A quirk of these retirement plans is that when you leave a job—voluntarily or not – you don’t have to keep your 401(k) at the old job.
Some employers allow new employees to bring their old 401(k) into the new plan. Another option is to do a 401(k) rollover: You move the money out of the 401(k) and into an IRA at a brokerage firm. Rollovers are big business for financial service firms: In the 2015 tax year, the IRS says $473 billion was rolled over into IRAs, and that is surely rising as many baby boomers are now in, or headed into, retirement.
There are some very smart reasons to do a rollover, but there can also be some good reasons to leave your 401(k) right where it is.
401(k) rollover: The pros
- You’re in a sucky (read: expensive) 401(k): While you are an employee you are typically held hostage by the line-up of funds your 401(k) offers.
Every fund in your plan charges an annual fee, called the expense ratio. This is also true of collective investment trusts (CITs) that some plans offer in the place of straight-up funds.
You will never see the expense ratio in a statement; it’s shaved off of your gross return before your net return is reported in your statement. (That said, it is super-easy to look up the expense ratio for every fund).
The most recent scouring of annual government filings puts the average stock fund asset-weighted expense ratio at 0.46%. That’s just an average. If you worked for a big employer you should be paying less; smaller plans tend to have higher fees.
Check what you’re paying, and then compare that to 0.05% to 0.10%. That’s the high end of what you would pay if you did a rollover and invested in any number of low-cost index mutual funds and exchange traded funds (ETFs).
Fees aren’t sexy, but they matter. A lot. If you have $100,000 in a stock fund that grows an annualized 6% over the next 10 years, you will have about $171,000 if the fund charges an 0.50% expense ratio, and more than $177,000 if your annual expense ratio was 0.10%.
Your new job has a fantastic 401(k) … and they allow you to “roll in.” Again, fees are a big consideration. If you are moving from a small company to a big one, chances are your new plan offers funds with much lower fees.
You are near retirement and need to simplify your financial life. Got a few straggler 401(k)s you left behind at old jobs? That can make it hard to have a unified asset allocation strategy. And managing your required minimum distributions (RMDs) in retirement will be easier if all the accounts are rolled over to one account at a discount brokerage.
401(k) rollovers: The cons
Your 401(k) has to have your back. The insurance guy telling you to move your 401(k) to something he’s selling doesn’t. Your employer is the sponsor of your 401(k). And all 401(k) sponsors must act as a fiduciary. That’s a too-fancy word for looking out for your best interests.
Out in the real world, some financial pros also operate as fiduciaries, and plenty don’t. Any financial pro who relies on earning a commission based on what he sells may be prone to offer conflicted advice: What is best for you may not be what will earn him the highest commission.
The Trump administration recently put the kibosh on a proposal that would have required anyone doling out retirement advice to act as a fiduciary. That leaves you vulnerable to the army of non-fiduciaries purporting to be “retirement income” experts, who are eager to get you to roll over your 401(k) into some commission-based investment (insurance with an investment component is popular) that earns them a fat commission and often charges high ongoing fees that you may not even be aware of.
To be clear: You can roll over a 401(k) to an IRA at a discount brokerage and invest in low-fee funds and ETFs without paying any commission.
In 2015, the Council of Economic Advisors estimated that conflicted advice reduces investor returns by 1 percentage point annually. If you have a $500,000 portfolio that earns 5% rather than 6% annually, after 10 years you would have around $815,000 rather than nearly $900,000.
Staying put in your 401(k) – especially if it offers low-fee funds – is one way to avoid getting snookered into a costly rollover sold by someone with conflicted advice. Or you can seek out financial pros who only operate as fiduciaries. Anyone you consider working with should volunteer – in writing – that he or she operates as a fiduciary.
You don’t currently have any IRA accounts and are interested in a Roth conversion. Any money saved in a traditional retirement account – 401(k) or IRA – is subject to income tax when you eventually withdraw it to spend in retirement. And once you hit age 70.5 you must make withdrawals, called required minimum distributions (RMDs).
A strategy that works for many people is a Roth conversion: You roll over your 401(k) into a traditional IRA, and then convert the traditional IRA to a Roth IRA. You owe tax on the converted amount when it is converted, but if you do not have any existing IRAs your tax bill will be less. That may be a reason to keep your money in a 401(k) and then sit down with a trusted tax pro with Roth conversion expertise to suss out whether a Roth conversion will make sense for you.
You could be sued or file for bankruptcy. Assets in a 401(k) are fully protected from bankruptcy and most legal judgments (IRS tax liens are one big exception). Money in an IRA has limited bankruptcy protection of $1.362 million in 2019.
You own company stock within your 401(k) account. If you roll over company stock into a traditional IRA you will eventually owe income tax on every penny you withdraw in retirement.
A strategy called net unrealized appreciation (NUA) could save you plenty in tax on your company stock. With NUA you would move company stock out of the 401(k) and into a regular taxable account. When you do that, you will immediately owe income tax on the original value of the stock – your cost basis. The potential tax advantage is that all the earnings on that stock will be taxed at your long-term capital gains rate. That rate is typically 10% to 15% for most households, far below today’s income tax rates.
As you work through your rollover options keep in mind that this need not be an all-or-nothing decision. You might find that it makes sense to roll over some 401(k) accounts and leave others right where they are.