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,” observed Jordan Sowhangar, vice president at Girard, a Univest Wealth division in King of Prussia, Pa.
For many, just leaving their 401(k)s alone might be an option, he said. However, while that might have been fine during employment, when they were younger and still accumulating assets, most retired clients find their situation has changed. They are “now facing different circumstances,” he said.
Among the new considerations, Sowhangar cited the shorter investment time horizon, the need to manage on a fixed income, potentially higher healthcare expenses, and required minimum distributions after age 73.
“It is, therefore, more important than ever to have control over your possibly largest source of liquid assets,” he said.
For most clients, it probably makes sense to convert 401(k) assets to an IRA, or several IRAs, advisors say. The reasons are many.
“I have almost never seen a 401(k) offer more cost-effective options than what you can achieve in an IRA,” said Rachel 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.”
Consolidation to an IRA can simplify accounting, inheritance, and RMDs, she explained. Moreover, IRAs generally provide a much broader array of investment choices than 401(k)s, with ETFs, 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 said, rather than a 401(k) manager who is responsible for countless employees.
The simplest way to move assets from a 401(k) to an IRA is via a direct rollover, experts agree. This can be done by the financial institution that manages the 401(k) to the one that manages the IRA. A rollover between like types of accounts—that is, from a traditional 401(k) to a traditional IRA, 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 will generate income taxes, advisors caution.
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, however, the full amount must be transferred to IRAs. So clients have to come up with funds to compensate for that 20%.
Whatever the advantages of IRA rollovers, some advisors insist 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,” said 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.”
He acknowledged, however, that those who are in plans with higher fees and/or who have a high level of financial literacy may be better off rolling those assets into an IRA.
Be aware, though, that there are other downsides to rolling 401(k) assets into IRAs, advisors say. ”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, said 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, she added. 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 said, so they don’t have to worry about their portfolio.
401(k)s also often allow for penalty-free emergency withdrawals at a younger age than IRAs do. “In many 401(k) plans, you can withdraw from your account in retirement without a penalty at age 55,” she explained. “You don’t have to wait until you are 59½, like with an IRA. This can be useful if you retire early.”
In addition, many 401(k) plans benefit from economies of scale for investment purchases and financial advice, giving them “lower costs for clients, compared to IRAs,” said Brett Bernstein, CEO of XML Financial Group in Bethesda, Md.
For him, the rollover decision boils down to resolving 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 said.
Clients who are facing or anticipating legal troubles might also prefer the protection from bankruptcy claims that 401(k)s provide, said CFP Board Ambassador Kurt Whitesell, a vice president at Summit Wealth Group in Rapid City, S.D. “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 added, which can be a distinct advantage—particularly for clients who 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,” said Whitesell.
Another consideration in choosing a rollover, he said: Traditional IRAs can later be converted to Roth IRAs, which is a taxable event but enables the money to remain tax-free thereafter and eliminates RMDs. Alternatively, IRA holders age 70½ or older can donate up to $105,000 to charities instead of using that money for RMDs, he said. Neither of these options are 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, advisors explain. 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. 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 option, though, since penalties and taxes will likely be due. “Cashing out is hardly ever a good idea,” said Turner at the Pension Policy Center, 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.