Should You Roll Over Your 401(k) into an IRA?

A 401(k) account is company-sponsored retirement savings account wherein an employee can contribute a portion of their paycheck which may or may not be matched by the employer. The accumulated funds are invested in various investment options such as mutual funds, stocks, bonds, etc. to supplement your income and sustain you financially when you have retired and no longer have a regular income to maintain your lifestyle.

As per a report by the American Benefits Council, 80 million-plus people in the US actively contribute towards a 401(k) plan. As of March 31, 2021, the 401(k) fund had an estimated $6.9 trillion worth of assets. This represents more than one-fourth of the entire $32.2 trillion US retirement market. Herein, the market is composed of several plans including employer-sponsored programs, annuities, defined contribution plans, and individual retirement accounts (IRAs). 401(k) accounts are largely popular due to the tax advantages they offer wherein your 401(k) investment earnings are not taxed until you begin to withdraw them, which primarily occurs after your retirement. 401(k) plans were first introduced in 1978 and since then have become one of the most popular and sought-after retirement plans in the US.

Even though a 401(k) plan offers several benefits for retirees, it also has its fair share of disadvantages, like strict restrictions, penalties, and tax implications on withdrawals. To circumvent some of these drawbacks, you may consider rolling your 401(k) plan into an IRA. An IRA or Individual Retirement Account is a tax-advantaged retirement savings account that can be opened by any individual, unlike a 401(k) plan which can be obtained only through an employer. If you choose to convert your 401(k) plan into an IRA, you can avail of the following advantages:

• Access to a wider, more comprehensive range of investments compared to a 401(k) account
• Long-term tax-deferred growth of funds
• Tax exemptions at the time of withdrawal of funds

Though, before going ahead with a rollover from a 401(k) account into an IRA, consult with a professional financial advisor to understand whether a rollover would be suitable for you or not based on your present financial situation and retirement objectives, and to understand the tax implications this decision may have.

Before you decide to convert your 401(k) into an IRA, it is best to go through the advantages and disadvantages of such a decision.

What are the Advantages of Rolling my 401(k) into an IRA?

A few of the benefits of converting your 401(k) into an IRA are as follows:

1. Wider range of investment vehicles available to choose from

In a 401(k) account, you have limited options when it comes to investing your funds. Your choices are restricted to mutual funds – equity funds, debt funds, and bond funds. This is not the case when it comes to an IRA. Here, apart from mutual funds, you can also invest in stocks, bonds, ETFs, real estate, etc. In addition to this, you can also purchase or sell your investments any time unlike in the 401(k) plan. A majority of 401(k) plans place restrictions on the number of times you can purchase or sell your investments or rebalance your portfolio.

2. Lower fees and costs compared to a 401(k)

IRAs have considerably lower fees and costs compared to a 401(k) such as lower management fees, administrative charges, and fund-expense ratios, and more. Additionally, the transaction costs are also comparatively higher in a 401(k) to an IRA.

3. Fewer complex rules

Compared to a 401(k), in an IRA there are fairly standardized rules mandated by the IRA. For instance, in a 401(k), each employer plan has different terms that add to its complexity.

4. Lower taxes

As mentioned previously, in an IRA you have to pay lower taxes compared to a 401(k). The IRS mandates that 20 percent of distributions be kept for federal taxes in a 401(k) account which is not the case in an IRA. You can either choose to specify a percentage that you may wish to withhold in your account or not keep any tax withholdings at all. Though, it is advised that you should allow a small percentage to be withheld to avoid paying hefty taxes at the end of the year. In an IRA, you can harness the power of compounding since your taxes are deferred and you can select the amount that you wish to withhold for federal taxes rather than an automatic 20 percent.

5. The Roth advantage

The major advantage of a Roth IRA is that you can pay taxes at the time of contribution allowing you to withdraw your funds in retirement on a tax-free basis. This entails that you can pay taxes when you're earning a stable income instead of deferring them post-retirement when you won't have a regular income. Additionally, in a Roth IRA, you are not mandated to take RMDs (Required Minimum Distributions) at age 72 either.

What are the Disadvantages of Rolling a 401(k) into an IRA?

Let us discuss some of the disadvantages of an IRA rollover:

1. Non-availability of loans

You will not be able to take out a loan from an IRA which you can do if you have a 401(k). This is useful if you need funds on an urgent basis.

2. Restrictions on withdrawals

There are certain restrictions on withdrawals on an IRA such as you cannot make a withdrawal unless you are above 59.5 years of age. If you withdraw money before reaching the cutoff age, you will have to pay an early withdrawal penalty of 10 percent. This is not the case with a 401(k) account as you can avoid paying the 10 percent early withdrawal penalty if you leave your job at the age of 55 or after the age of 55. In addition, you can avail favorable tax treatment on withdrawals if your 401(k) is directed in company stock. This facility is not available to an investor having an IRA.

3. Higher fees to be paid

In an IRA, you may have to pay higher account fees compared to a 401(k) where you can buy funds at institutional pricing rates, owing to group buying power.

4. Limited legal protection

If you have a 401(k) account, you are better protected against lawsuits, bankruptcy, and creditors since it is covered by federal laws. On the other hand, IRAs are protected only by state laws, which vary from state to state.

When Should You Consider Converting my 401(k) into an IRA?

You should consider converting your 401(k) into an IRA in the following cases:

• You believe that you would end up being in a higher tax bracket, or if tax rates are likely to be higher during your retirement.
• Your current 401(k) plan is not performing well due to having high-cost investments and underperforming funds.
• You have several 401(k) accounts and it has become problematic to manage them all due to frequent changes in jobs.
• You need to rebalance your 401(k) since it has gotten burdened with weak stocks having a low fixed income and needs to counterbalance with bond funds.
• You require greater flexibility in terms of withdrawals.

Alternatively, you should not opt for a 401(k) conversion into an IRA, if:

• You are looking at early retirement, thereby, would need early withdrawals.
• Your earnings would exceed the income cap placed on a Roth IRA.
• You do not want to expose yourself to any kind of legal battle or lawsuit in the future.

Which IRA Should I Rollover to?

If you are set in your mind that you want to convert your existing 401(k) plan into an IRA, you need to ensure that you choose the right type of IRA for conversion. Let’s go through some of the guidelines:

• If you envision your taxable income or overall tax bracket to be lower during your retirement, you should go for a traditional IRA. But if you expect your taxable income or the overall tax brackets to be higher during your golden years, then you would be wise to choose a Roth IRA.
• If you are a high net worth individual (HNWI) or a high income-earner, you would be better off choosing a traditional IRA since it has no cap on income, unlike a Roth IRA wherein certain income limits act as a deterrent for HNWIs to contribute to it.
• If you wish to take out an early withdrawal and want to avoid paying a penalty, you should consider converting your traditional IRA to a Roth IRA, as you can make early withdrawals provided they meet certain conditions such as first-time home purchase, college expenses, and birth or adoption expenses.
• Before you can make a withdrawal from a Roth IRA account, you need to have held the account for at least 5 years and be 59.5 years of age or older. Moreover, there are no minimum time restrictions that need to be met before you take a distribution of money.

How Can I Roll Over My 401(k) Into An IRA?

You can convert your 401(k) into an IRA fairly easily. Let us go through the steps:

1. First off, you have to inform your 401(k) plan administrator or your company HR explaining that you have decided to rollover your 401(k) into anIRA and get an application form for the same.
2. Afterward, contact the concerned custodian of your chosen IRA, be it a traditional IRA or a Roth IRA. You can now go ahead and open an account.
3. Once your account becomes active, use the forms sourced from your company HR or your 401(k) plan administrator to request a direct rollover of funds into your chosen IRA.
4. Once your request gets approved, the administrator will transfer the funds into your new IRA account. You could also request the administrator to furnish you with a check in the name of the IRA. Ensure that the check is not presented as a distribution.
5. You also have the option of choosing an indirect rollover wherein 20 percent of your 401(k) will be withheld for taxes by the administrator. You may apply for a tax refund at a later date.

Is There a Time Limit to Complete the Rollover?

If you opt for a direct rollover of your 401(k) plan, typically there is no time limit for completing the rollover. Once your IRA is set up, the funds would be transferred to your new account. However, if you choose to rollover your 401(k) account to an IRA using the indirect method, you have a 60-day limit to complete the rollover. Your 60 days would start from the date you receive your retirement plan distributions. The IRS may waive this rollover requirement in certain situations such as if you missed the deadline due to extenuating circumstances beyond your control. Lastly, you can only do one rollover annually.

What are the Taxation and Penalties In a 401(k) Rollover?

If you go ahead with a 401(k) rollover, you have to take heed of the following taxation and penalties:

• While converting your 401(k) to a Roth IRA, you would have to pay income tax on the funds transferred by you in the year you make the switch. This can be circumvented at the time of your retirement as you would not have to pay any tax on withdrawals provided you have held the account for 5 years and are above 59.5 years of age.
• When you make the switch to a Roth IRA, then the holding period for the transferred funds becomes zero. You must hold the said account for at least 5 years before you can make a withdrawal. Also, you must be 59.5 years or older to ensure penalty-free withdrawals. If you do not adhere to the said rules, you may be subjected to a 10 percent penalty and income taxes.
• If you opt for an indirect rollover, then you must complete the rollover within 60 days from the date you receive your 401(k) distributions. If you are unable to meet the said deadline, then you would be liable to pay withholding taxes (20 percent) and penalties.

Should I Convert my 401(k) Into an IRA?

Ultimately, only you can answer this question. Choosing to convert your 401(k) plan into an IRA is dependent upon your financial situation and goals. If you would wish to pay lower taxes and fees, have access to a wider range of instruments to invest in, better communication, less number of rules, etc. then you should rollover your 401(k).

According to studies, an average American needs 85% of their pre-retirement income to live conservatively in retirement. Retirement savings plans such as a 401(k) plan can fail to meet the aforesaid target due to several factors such as the restricted potential to earn higher interests due to limited choice of investments it offers, inflation causing a rise in prices of goods and services in future, and more. Many financial experts are of the view that a 401(k) is not prudent enough in its investment strategy to consistently beat the rate of inflation. Putting all your eggs in the 401(k) basket could possibly leave you with lesser funds than foreseen by you during your retirement years.

Are There Any Other Alternatives to Rolling my 401(k) Into an IRA?

Apart from converting your 401(k) to an IRA, you also have these alternatives available to you:

• A 401(k) to a new 401(k) transfer: If you are switching companies, you can rollover the funds in your traditional 401(k) account to a new 401(k). You will not have to pay any taxes on the transfer.
• A 401(k) to a Roth 401(k) transfer: You can rollover your traditional 401(k) account into a Roth 401(k) plan wherein you can avail of certain tax advantages such as after-tax contributions up to a specified limit and tax-free distributions during your retirement.
• Net Unrealized Appreciation (NUA): Herein, you can own company stocks where you work. Usually, companies engage in this practice to give employees a sense of ownership. NUA refers to the difference between the cost of employer shares and the present market value of the company shares. This means that if you own high-appreciated company shares in your 401(k) holdings, you can use the NUA to your benefit. You can capitalize on favorable capital gain tax rates charged by the IRS on the NUA of the employer at the time of distribution provided you satisfy some specific qualifications.

To Conclude

At the end of the day, the decision to rollover your 401(k) into an IRA should be made after evaluating the suitability of each account, as per your and financial situation and objectives. Both 401(k) and IRA plans have their pros and cons, thus, you should make an informed decision after doing the necessary research. However, if you feel that the rollover is a complex and complicated affair, you can reach out to a professional financial advisor to help guide you through the conversion process.

For further guidance on the most suitable retirement account for your needs, use the free advisor match tool and get matched with 1-3 vetted financial fiduciaries who may be able to create a customized retirement plan for you. You may set up an interview with the financial advisors before you decide to engage with one.