Helping clients decide what to do with their 401(k)s after they leave the workforce can be complicated. There are many factors to consider, from investment returns to taxation to inheritance issues and so on.
Experts have some advice.
“Most [retirees] are not managing or even looking at their 401(k)s, yet for the majority of clients this is their largest source of accumulated assets and wealth,” says Jordan Sowhangar, vice president at Girard, a Univest Wealth division in King of Prussia, Pa.
While it might have been fine for them to just leave their 401(k)s alone before when they were young and accumulating assets, she says, retired clients have found that their situation has changed. She points to their shorter investment time horizon, their need to manage on a fixed income, their possibly higher healthcare expenses and the required minimum distributions they have to take after age 73. “It is, therefore, more important than ever to have control over your possibly largest source of liquid assets,” she says.
For most clients, it probably makes sense to convert 401(k) assets to an IRA, or several IRAs, advisors say. “I have almost never seen a 401(k) offer more cost-effective options than what you can achieve in an IRA,” says Rachael Camp, a CFP Board ambassador and founder of Camp Wealth in Denver. “IRA accounts allow for consolidation and simplification, provide the ability to choose a custodian you like, and offer unlimited investment options.”
Clients can simplify their accounting, inheritances and required distributions by consolidating their assets in an IRA, Camp explains. These accounts generally provide a much broader array of investment choices than 401(k)s, with options such as exchange-traded funds; annuities; and alternative investments such as precious metals, real estate and even hedge funds. IRAs also offer the freedom to work with any investment advisor, she says.
Some 401(k) plans also have higher fees, which can make IRAs preferrable, especially if the clients are more cost-sensitive or investment savvy.
The simplest way to move assets from a 401(k) to an IRA is via a direct rollover by the financial institution managing the 401(k) to the one managing the IRA. A rollover between similar accounts—from a traditional 401(k) to a traditional IRA, say, or from a Roth 401(k) to a Roth IRA—is tax-free and typically the least expensive option. Rolling over assets from a traditional 401(k) to a Roth IRA, however, will generate income taxes.
Some clients prefer an indirect rollover, meaning they receive a check from the 401(k) and redeposit it themselves into the IRA of their choice. This is risky, say experts, because there are penalties for not moving the money within 60 days. The IRS might view the 401(k) distribution as a taxable withdrawal, not a rollover, and there could be additional penalties as well.
Worse still, market watchers warn, in many cases employers are required to withhold 20% of 401(k) withdrawals for potential taxes. For the indirect rollover to satisfy the IRS, the full amount must be transferred to IRAs. So clients have to come up with funds to compensate for that 20%.
Why Stick With Your 401(k)?
But even with the advantages of rolling over, advisors say there are circumstances where it may be best to leave funds in a 401(k).
“Most 401(k) participants are in large plans with low fees and an adequate number of good investment options,” says John Turner, director of the Pension Policy Center in Washington, D.C. “Also, most participants have low financial literacy, which means that they are not capable of dealing with a wider range of financial assets with differing levels of fees. Thus, most participants are better off staying in their 401(k) plans.”
There are other downsides to rolling over—for instance, you lose the ability to take loans from your employer plan. “Rolling over a 401(k) to an IRA might be a bad idea if you anticipate needing a loan from your retirement fund, as most 401(k) plans allow for a loan up to the lesser of half the account value or $50,000,” which IRAs don’t, says Dina Leader Powers at Fairway Wealth Management in Independence, Ohio.
It can be hard for clients to choose their own IRAs, too, if they don’t have financial guidance tailored to their particular situation, Powers adds. Many 401(k)s benefit from managers with a fiduciary obligation to their members. Furthermore, 401(k) assets might be in a target-date fund that automatically rebalances the client’s portfolio over time, she says, so they don’t have to worry about their portfolios.
Another advantage of the 401(k) is that it often allows people to take penalty-free emergency withdrawals at younger ages than they could in IRAs. “In many 401(k) plans, you can withdraw from your account in retirement without a penalty at age 55,” Powers says. “You don’t have to wait until you are 59½, like with an IRA. This can be useful if you retire early.”
In addition, the size of many 401(k) plans gives them scale, which means they can charge less for investment purchases and advice, says Brett Bernstein, CEO of XML Financial Group in Bethesda, Md.
For Bernstein, the rollover decision boils down to four key questions: What is the client allowed to do with the funds if they stay in the 401(k) after retirement? What investment choices does the 401(k) offer? What are the costs? And what access to personalized financial guidance does the 401(k) provide? “Once those questions are answered, you can make an educated decision about what is best,” he says.
A 401(k) plan also offers more protection to clients facing or anticipating legal troubles or bankruptcy claims, says Kurt Whitesell, a vice president at Summit Wealth Group in Rapid City, S.D. (he’s also a CFP Board ambassador). “If you are in the middle of a lawsuit or have one pending, rolling over your 401(k) could be a bad idea. ... The protections within a 401(k) are stronger than they are for IRAs.”
Still, clients who choose IRA rollovers have the option of working with their own trusted advisor, he adds, which can be a distinct advantage—particularly if the clients aren’t financially sophisticated. “Many 401(k) plans may offer help, although when you call the 800 number you have no idea of the experience of the customer service representative on the other end of the call,” Whitesell says.
Another consideration in choosing a rollover, he says, is that traditional IRAs can later be converted to Roth IRAs. That triggers taxes, but the money remains tax-free after that and eliminates required minimum distributions. Alternatively, IRA holders age 70½ or older can donate up to $105,000 to charities instead of using that money for RMDs, he says. Neither of these options is viable for 401(k)s.
For some clients, estate planning will also be a factor. When an IRA account holder dies, the IRA automatically passes to named beneficiaries. If no beneficiary is specified, however, the IRA goes to the estate and to probate, which can be complicated and expensive. The rules are a little different for 401(k)s—with those, at least half of all assets must go to a surviving spouse if there is one, unless specific instructions were left for some other beneficiary. Again, if there is no spouse, heirs may be looking at probate.
Of course, retirees can always simply liquidate their old 401(k)s and put the money in the bank. Advisors don’t typically recommend this, though, since penalties and taxes will likely be due. “Cashing out is hardly ever a good idea,” says Turner, noting a possible exception if the client has a small 401(k) with only a few thousand dollars in it and desperately needs the extra cash.