Reasons To Rollover A 401(k) And The One Reason Not To
Updated: Jan 31
New “fiduciary” rules have recently made even the staunchest proponents of rolling over your 401(k) to an IRA change their minds regarding the recommendation.
As someone that has not changed my belief in the benefits of removing money from conflicted 401(k) providers at nearly every opportunity, I wanted to list several that came to mind. This list is not exhaustive, though it shows the vast benefits to an IRA and the shallow arguments against rolling a 401(k) to one.
Tax reasons to transfer a plan to an IRA include:
401(k) withdrawals don’t allow for tax planning. Contributions can be pre-tax, after-tax, or Roth, but withdrawals are pro-rated and do not allow a choice of which bucket to withdraw from.
Save taxes on employer stock investments. For those who own employer stock in a 401(k), there may be tax benefits to doing a total account transfer alongside withdrawal of the company stock.
Pay healthcare and insurance costs. If you have significant healthcare needs, IRA money can be used to pay them, but the IRA also provides benefits for health insurance premiums while unemployed.
Pay for college. IRA funds can be withdrawn penalty-free to pay for qualified education costs for yourself, spouse, children or grandchildren.
Purchase a home. IRA funds can be used for a first-time home purchaser. This benefit
extends to your child, grandchild or parent up to $10,000.
Pay for useful financial advice. IRA funds can pay for financial advice on the IRA from an independent advisor and this withdrawal is generally both tax-free and penalty-free. This means that many could save 20-40% on advice costs by rolling over and paying for their advice from an IRA.
No requirement to withdraw from Roth IRAs. Savers with Roth 401(k) money will have to make a Required Minimum Distribution from their accounts at age 70½, whereas there is no such requirement in the Roth IRA.
In addition, below are just a few reasons from an investment perspective to gain control of your retirement funds by transferring to an IRA.
Most who look for an advisor will admit to not managing their assets. Most prospects will not seek out independent financial planning until the years just before retirement or when they can transfer a 401(k)-plan due to some other work termination. They need this service and generally have more accounts and complex needs than a 401(k) advisor can assist with.
If investors do hire advice from the 401(k) provider's chosen firms, it’s conflicted, far more limited, and usually more costly compared to independent advisors. This is a major conflict that fiduciary rules simply pretends does not exist (which, makes one wonder what industry is writing these rules). Asset allocation models are often free online to major companies, and yet there is an industry dedicated to making participants believe they are receiving comprehensive investment advice, rather than simple modeling and rebalancing.
401(k) plans do not have full asset class menus. By law, certain assets cannot be held in the 401(k), so this problem will never be solved. There are many studies which show this can cost several percentage points per year, adding unnecessary years to employment.
Overallocation is risky. Overallocation is the inevitable result harming millions of 401(k) participants today. Not having a full range of investment options puts savers at risk that the few options they have will underperform, rather than having access to total diversification.
The investment selection is meant to protect the employer, not serve investor needs. This has become obvious as plans have shifted from providing employees with free asset allocation guidance to charging for that option. The plan sees the company as the client, not the participant.
Asset-location is rarely possible in 401(k) plans. If you have a Roth 401(k) and a pre-tax 401(k), these accounts are most often held in the same funds. Studies have shown these strategies can add significant gains and extend portfolio life by years.
The menu and provider are always subject to change. To avoid litigation plan sponsors may make changes just to make changes. I see many plans today making similar changes when a manager leaves a fund, which may suggest that plans prioritize lawsuit protection over doing what’s best. Insecurity is hardly an ideal characteristic of a retirement financial plan.
Most 401(k) plan providers are not fiduciaries. There are many reasons these plans can never be held to a similar standard as independent advice.
Not all tax strategies are available. Many who retire prior to Social Security or who have an unexpected separation find themselves in the ideal situation for a Roth conversion - relatively low income compared to what they expect in the future. However, many plans-even those that offer Roth 401(k) accounts-do not allow for conversions.
401(k) providers have significant conflicts. Fidelity today is defending itself from using funds that allegedly make secret payments to be pushed on their plan participants, but even if these payments are ignored, many providers today offer their own proprietary funds rather than others that may have better performance.
The last bullet point often results in social costs that benefit attorneys and create risk for future participants.
401(k) social costs. Employer retirement plans make publishers like Forbes responsible for becoming experts in investment management, which results in their managing a plan at the lowest level to avoid liability, not to do the most for their investors. Plans deny their savers access to independent advice they need throughout their working years, and the result is most do not plan until separation from service. Plans require company resources to run and in our litigious times, they cost companies capital to defend their plans in court; money which should go toward more productive uses, like hiring more employees.
If you separate from service after age 55 many plans will allow for penalty-free withdrawals before 59 ½. The age for penalty-free withdrawals from a 401(k) can be slightly before the IRA age of 59½ when the penalty would go away. There are many ways to avoid the IRA penalty, but often I will advise leaving enough to cover your needs until 59½ in the 401(k) and roll over the difference.
Finally, the excuse many use to propose rules (“fiduciary” rules) blocking transfers when someone hires a financial advisor at retirement to help with the management of their IRA is that there is some sort of Marxist-style “conflict” when advisors recommend transferring a 401(k) plan to an IRA. The argument is that a conflict is created because an advisor may be compensated (but, the argument ignores the massive conflict with the 401(k) firm and the often secret compensation they receive).
As investors can see for themselves see from the massive amount of benefits to transferring to an IRA, nothing can be further from the truth. Moving money out of a conflicted 401(k) plan or 401(k) asset-allocation investment advisor to an IRA has numerous benefits, and some will have a temporary reason to leave the plan behind.