The other day a client sent over his wife’s new 401(k) investment options, looking for some advice. My advice was very simple. Get out of this 401(k) plan as fast as you can! It was the worst of the worst of 401(k) plans. First, each participant was charged 1.25% annually, just to be enrolled in the 401(k) plan. Next, every investment option cost 1 to 1.5% annually. Last, every participant was charged another $50 per year for administration costs, and if she wants to take a distribution from the 401(k), she has to pay $50 each time. Add up all of the fees, and she will pay nearly 2.5% annually for a bad plan, with crummy investment options. As soon as she retires, she should get out of this plan as soon as she can. This is the nightmare 401(k) scenario, but they aren’t all that bad. In fact, many 401(k) plans are quite a bit better than rolling the funds over to an IRA. This article describes those situations in which you should keep money in your 401(k) when you retire .
First, some rollover IRA basics. When you retire, and typically even when you are working and over age 59 ½, you have the option to roll your 401(k) into an IRA. If you have a pre-tax IRA, you can roll the 401(k) into a traditional IRA and continue to grow the funds, tax deferred. If you have some Roth 401(k) money, and even after-tax contributions, you can roll this money to a Roth IRA and the Roth account will continue to grow for you tax-free. Many people also ask if they can roll a pre-tax 401(k) into a Roth account. Yes, you can do this but you pay taxes on the full amount of the conversion from the pre-tax accounts into the Roth accounts. There can be some reasons for rolling over your 401(k) into an IRA. The main benefits are that you have more investment options in the IRA and much more flexibility. In the example above, she would have far fewer fees and more flexibility, which means rolling over her 401(k) a no-brainer. For others though, the decision is not as easy and there are actually some good reasons to keep the 401(k). This post discusses some of those reasons that you should consider keeping the 401(k) in retirement and not roll the money into an IRA.
The age 55 rule
If you are lucky enough to enjoy an early retirement, you may want to hold onto your 401(k). You have probably heard that you need to be over age 59 ½ in order to take penalty free withdrawals from your IRA. In an IRA, distributions prior to age 59 ½ are subject to a 10% early withdrawal penalty. There is a little known rule that allows you to withdraw money earlier from your 401(k) penalty free.
If you retire from your job after the year in which you turn 55, you can take penalty free distributions from your 401(k). For example, if your birthday is in July, you could leave your employer the January in the year in which you turn 55, or anytime later, and be eligible for penalty free withdrawals. This is a huge benefit because you have to be over 59 ½ to withdraw money from an IRA penalty free. For any of my clients that are retiring prior to age 59 ½ but after age 55, I strongly recommend keeping some or all of their money in the 401(k). One quick note here, you can’t retire or leave your employer prior to age 55 and then take out money from your 401(k) at age 55, penalty free. You must have retired after you reached the year in which you have turned 55, to have access to your 401(k) penalty free.
One of the biggest advantage a 401(k) offers is the ability to take a loan. I’m like most financial advisors and don’t necessarily recommend taking a loan from your 401(k), but there are times that it may make sense. For example, maybe you are buying your retirement home before selling your current house. A 401(k) loan can help bridge that gap between buying and selling your properties. The great thing about the 401(k) loan is the interest rates are fairly low, and you pay yourself back the interest. The problem I typically see with the 401(k) loan is when people constantly have high loan balances. The result is high repayments (which lowers additional contributions) and the loan is not in the stock market and growing for you. Still, as a last resort, a 401(k) loan can be beneficial and there are no loans allowed from an IRA. Once you are retired, you will need to check if loans are still available or if it is only for current employees.
As I mentioned before, there are times when the fees that you are paying in a 401(k) are outrageous. Especially, if you are part of a small company, the fees can really add up. Also, if your 401(k) is sponsored by an insurance company, you are probably getting hammered with fees. These fees may include a financial advisor fee, high expense ratios for the investment options, administrative fees, and additional fees for withdrawals, or placing trades. The 401(k) business can be a racket, and if you’re in a bad plan, there’s nothing that you can do about it.
On the other hand, the 401(k) may actually be far cheaper for you than rolling your money to an IRA. For example, both Ford and GM have investment options, that are much cheaper than what you would be able to get on the our own. Ford and GM have negotiated fees for certain investments, which may cost up to half of what you would pay for the same investment in your own IRA. There are also no loads, or typically commission charges on trades in the 401(k), and this can result in big savings. Also, many 401(k) providers offer very low investment advice, which you probably can’t get outside the plan. Ford offers Financial Engines, which is very low-fee investment advisor which Ford employees have access. If you roll the funds over to an IRA, you typically will pay higher fees with most investment advisors. Make sure you know and understand all of the fees in your 401(k) before making a final decision to roll all of your money into an IRA.
Stable Value Fund
Another feature of a good 401(k) plan is a stable value or income fund. These type of funds offer a guaranteed rate of return with essentially no downside risk. Not to mention, while most bond funds go down in value when interest rates rise, stable value funds actually become more valuable. This is because stable value funds increase their income yield when interest rates rise. Ford and GM offer stable value funds that yield nearly 2% per year. This may not make you rich, but certainly it is better than any savings account you can find right now. A stable value fund guarantees a modest rate of return, protects against market corrections, and actually gets better when interest rates rise. That can be a valuable component for retirees putting together a retirement income portfolio.
If you are a University of Michigan employee, or certain other non-profit organizations, and have a 403(b) through TIAA, you probably have access to the TIAA Traditional fund. The TIAA Traditional fund has some restrictions, such as annual withdrawal limitations, which makes it different than other stable value funds. Still, the TIAA Traditional fund guarantees a very high rate of return, which is nearly 4% per year currently. Try getting a guaranteed rate of return of nearly 4% outside of a 401(k). For more aggressive investors, or younger investors, you may not care at all about stable value funds which only guarantee a couple percent. For retirees though, this stable value fund can be a great benefit that you don’t have access outside of your employer provided account.
Less investment options
Wait, I thought we were talking about positive things here. How is having less investment options a good thing? Like it or not, many of us are not great at picking investments. 401(k) plans typically have a minimal amount of investments and even if you have no idea what you are doing, most 401(k) plans have a target timeline fund. No, target timeline funds are not the greatest investment options out there, but trust me, you could do worse. I have seen too many people roll money out of their 401(k) into an IRA, and then the money just sits in cash in the IRA. This may not have been the person’s intention, but he got confused looking at the thousand of investment options out there, and decided doing nothing was his easiest option. I have also seen the person who rolls their money into an IRA and then starts buying the hottest tech stock. Two months later he has lost a significant amount of his savings and scrambling to find the next big thing. Trust me, I would much prefer a boring target timeline fund over cash or the hot tech stock anyday. Investing is hard, and having more investment options isn’t necessarily a good thing for all investors.
Sure, there are reasons that you may want to roll your 401(k) over to an IRA. If you are paying very high fees in your current 401(k) there are some big advantages to rolling the money into a lower cost option. Also, if you have a Roth 401(k), there are some big benefits of rolling the money into a Roth IRA. If you are working with a financial planner, they are going to almost always require you to roll your 401(k) into an IRA. This isn’t because it is in your best interest, but rather the benefit of the financial advisor. Many times the only way a financial advisor can get paid, is through an IRA. Rolling money from a 401(k) can be advantageous, but first you need to know the pros and cons of your current 401(k). Remember, you don’t need to do anything, and there is nothing wrong (usually) to keeping the money in your 401(k). Remember, just because rolling your funds to an IRA is better for your advisor, doesn’t mean it is better for you.