Should I roll over my 401(k) to an IRA?
This is a very good question. Many people are asking this question because they've recently retired. And as with so many questions, the answer might not be the same for everyone, although in this case there is generally a better route for most people. Here we're going to go over some of the advantages and disadvantages of rolling over your previous employer's 401(k) to an IRA.
Age and Goals
One of the first things that we want to consider when we're deciding what to do with money in a 401(k) is to look at the person's age and their goals. There is one key rule that is very different between a 401(k) and an IRA regarding required minimum distributions. 401(k)s are not required to distribute any funds until the participant is retired. With IRAs, the required minimum distributions must start at age 72. So if someone plans to work past the age of 72 and they don't want to take these required minimum distributions, then certainly leaving the money inside of the 401(k) is a good idea.
As we get into the tax planning element of this question, this first element is arguably the largest difference between a 401(k) and an IRA. We want to understand that everyone has different goals and beliefs about the tax system, and everyone has different tax planning strategies. For example, let's say that someone held the belief that our country was moving towards implementing more socialist policies, meaning that taxes would be increasing in the near future. They likely would therefore not have a problem with the required minimum distributions now, nor would they have a problem converting the 401(k) to a Roth IRA, which would create an income taxable event. This also depends on their position in their current tax bracket. If someone's at the very bottom of a bracket without a conversion from a 401(k) to a Roth IRA, then they may not be concerned about making that move. Let's say they have a 401(k) of $95,000 and they're at the very bottom of the 22% bracket. They can rollover the entire $95,000.00 into a Roth IRA and still stay in the 22% federal bracket. That is just one example of where tax planning comes into play when considering this difference between a 401(k) and an IRA.
If someone quits their job or is terminated and keeps their money inside of their 401(k) rather than rolling it over to an IRA that's been created for them, they will not be required to take minimum distributions until they retire. So if they're working past the age of 72 and they didn't want to trigger more income at the time and pay higher taxes, then they would want to keep the money in the 401(k), at least for tax purposes, but there's more to look at than just taxes.
Bankruptcy and Creditors
Another advantage of 401(k)s is that they offer protection from creditors under federal law: during a person's bankruptcy proceedings, the assets they have inside of the 401(k) cannot be seized. With IRAs, protection from other types of creditors varies by circumstances and state, so we also will need to consider how a rollover from a 401(k) into an IRA is protected. This is an important difference, since you get more protection in a bankruptcy by leaving your money in a 401(k) than you do from rolling it over into an IRA. However, the difference is not that big particularly since the money is rolled over from a 401(k) into an IRA rather than having been put into an IRA directly, which offers less protection. So that's another advantage of 401(k)s, although this does depend on the state you're in.
Another advantage for the 401(k) versus the IRA is that in a 401(k) plan you may be able to borrow from it, whereas in an IRA you cannot. People may want to maintain the ability to do that with their 401(k) money. They may want to be able to take out a loan and get money out of their 401(k), which is basically tax-free. Of course they'd have to pay their own 401(k) back, but it's basically like borrowing money from yourself. It gives you access to the money before the age of 59 and a half without taxes or penalties if you pay the loan back according to the agreed-upon terms when you make the 401(k) loan.
So those are the three kinds of advantages that we see in 401(k)s versus IRAs:
- 401(k)s offer protection from creditors during bankruptcy that an IRA may not offer.
- Depending on the employer's plan, the participants can borrow from a 401(k), whereas they cannot borrow from their IRA.
- With 40(k)s you don't have to take required minimum distributions until you retire, whereas with an IRA you must begin taking them at the age of 72 under current law.
But it's not all one-sided.
Next we'll look at four strengths of IRAs
that we don't necessarily always have with 401(k)s.
One of the most important aspects of rolling your money into an IRA from a 401(k) is the investment options. This is the thing that I really talk about with my clients when they're considering doing this. They might have a 401(k) at a large famous place like Fidelity or Merrill Lynch, and because of the plan that their company has chosen they might only have 20 investment options. However, I use Charles Schwab for my clients' IRAs. If they were to open up an IRA at Schwab they would have thousands of different investment options that would allow them to get better diversification at a lower cost, which would presumably mean better performance for their portfolio. So that's number one for the IRAs: they usually offer more investment options.
Control and Trading Restrictions
Number two is that with an IRA, I feel like my clients have more control over their money. This again goes back to the investment options that they might be able to trade. Many 401(k)s have trading restrictions. For example, you might only be able to play six trades a year. Or you might have to wait six months after you've bought a security in order to sell it and move those funds to another investment option inside of the 401(k). With IRAs there are no such restrictions. You can buy and sell as you please and as your investment manager and investment advisors see fit. Also, as we mentioned previously, you have more investment options and that gives the investor more control.
Number three: when you're inside of an IRA you can choose between a Roth and a traditional. I've previously discussed how one of the best planning tools that I have for my clients to reduce taxes during retirement is a Roth IRA. It's a wonderful place to save money because when you're retired or when you withdraw the money, it is tax-free and it grows tax-free. You put money in after you've paid taxes on it, and when you take money out and there's no tax consequences. So with an IRA you can in fact go into a Roth, whereas with leaving your money in a 401(k) you typically cannot.
Another pro for Roth IRAs, not traditional IRAs, is that there is no required minimum distribution, which you can't get with 401(k)s. As mentioned previously in this article, 401(k)s require minimum distributions when a person retires. However, with a Roth IRA you don't have to take minimum distributions. The government has already been paid their taxes on the money before it goes into an IRA, so there is no required age to take those distributions.
Talk with Tommy Cloud
As you can see, this is one of the ways that we do planning with our clients, and it's something that each of you will have to decide for yourselves when you retire. I hope this article's been helpful for you in clarifying some of the advantages and disadvantages of rolling over your money from your 401(k) to your IRA when you leave your job.
Now, if you'd like to set up a free, no-cost, and no-obligation retirement-ready success call with me, simply click the link below. In just 20 minutes, we can discuss your retirement goals and whether or not you're on the right financial path to meet them. I look forward to hearing from you!
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