Moving from a 401(k) to an IRA

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When you leave an employer or transition into retirement, an important financial decision is whether to leave your money in your 401(k) or roll it over into an IRA. What is the difference between these types of accounts? Is an IRA a better option? The purpose of this podcast and article is to list 5 specific reasons you might consider moving from a 401(k) to an IRA. I’ll also mention some instances when it might not make sense.

THE RISE OF THE 401(K)

The percentage of Americans who have been covered by a defined benefit pension plan that is paid out as an annuity has been steadily declining the last 25 years. These plans were often characterized by a company paying a certain amount per month through retirement for a specific number of years worked, commonly based on a percentage of salary.

On the flip side, defined contribution plans (often a 401(k)) have been on the rise as employers transfer the risk of paying for retirement from their pocket to their employees.

Many employers offer 401(k)s to their employees, often matching a percentage of the employees contribution up to a certain amount. An added benefit is that these plans are tax-deferred or tax-advantaged, meaning that money put in a 401(k) is pre-tax money and will be taxed later when it is withdrawn. You’ll pay ordinary income tax, just like your salary, on your withdrawal. In most cases, accessing your 401(k) money prior to 59 ½ will add a 10% penalty.

For many reasons, there is a lot of wisdom in taking full advantage of your 401(k), especially up to the match. The employer’s contribution can be viewed as “free money” or additional salary.

That being said, if you’re near retirement and have been a saver, you’ve probably accumulated a significant portion of your retirement nest egg in your 401(k). It’s not uncommon to work with clients that have between several hundred thousand to more than a million in their 401(k)s and tax-deferred accounts.

5 REASONS TO CONSIDER ROLLING OVER YOUR 401(K) TO AN IRA

While a 401(k) can be a great tax-deferred financial vehicle, especially for those getting an employer match, it’s my belief that a 401(k) simply doesn’t give my clients the necessary tools they should have access to during their retirement years.

An IRA is also a tax-deferred vehicle just like a 401(k) but with additional options during retirement. While this isn’t a comprehensive article or podcast on the difference between a 401(k) and IRA, I’m going to touch on 5 reasons to consider an IRA.

#1 - GREATER INVESTMENT CHOICE AND FLEXIBILITY

The investment options in your 401(k) are selected by the plan administrator and aren’t up for negotiation. If you aren’t ecstatic about the investments available, there really isn’t anything you can do about it. Also, the investment choices are built for the masses and aren’t generally customizable, meaning vanilla is all you’re going to get. There are a limited number of choices available.

An IRA, on the other hand, has thousands of investment options, depending on who you work with. The flexibility of an IRA gives experienced wealth managers and investors choice and control.

An example of this flexibility can occur when an investor reaches the age of 70 ½. If you want to give to charity (i.e. tithing to your church), you can donate directly to your charity from your IRA in the form of a QCD (Qualified Charitable Distribution). A QCD excludes the amount you donate from taxable income and counts for your RMD (Required Minimum Distributions) at 72 and beyond. A QCD is available in an IRA but not in a 401(k).

#2 - ACCESS TO COMPREHENSIVE PLANNING

In the earning years, most investors are primarily interested in growing their assets. As they approach retirement, a whole new set of challenges and opportunities present themselves. Decisions around Social Security, medical planning, estate planning, protecting assets from market volatility, and creating an income plan to replace your paycheck during retirement need to be made.

Many retirement specialists, who are comprehensive in nature, most often work with IRAs and don’t have access to your 401(k) assets. They can not only help you create retirement plans around growing and distributing your investments but also help you work through the many other planning areas, such as proactively minimizing taxes during retirement. I highly recommend using a fiduciary financing advisor. Many of these retirement specialists will charge a percentage of assets under management (i.e. 1%) and for that fee you’ll get access to comprehensive retirement advice and investment management, usually semi-annually or annually.

#3 - SIMPLIFICATION

It’s not uncommon for individuals to work for several different companies during their working years. Each of these companies will often have their own 401(k)s and benefit options. Once an employee leaves a company, you can generally transfer the funds to another 401(k) or IRA, no matter your age.

As an individual approaches retirement it’s very possible to have several 401(k)s with different institutions. Many investors can simplify their finances by rolling over their 401(k)s to a single IRA. It’s almost never a good idea to withdraw your money from a 401(k) before 59 ½, as you’ll pay ordinary tax rates and an extra 10% penalty (see the Rule of 55 below for the exception). If you, however, transfer your 401(k) directly to another 401(k) or IRA, you won’t incur that 10% penalty. You do need to make sure you do transfer the right way, however. Doing this incorrectly can create large tax consequences.

As an additional item of note, an IRA and 401(k) are in an individual’s name. That means that you can’t move a 401(k) in one person’s name to an IRA of the spouse. The IRA would also have to be in the same person’s name as the 401(k).

#4 - DIFFERENT TYPES OF IRA ACCOUNTS

A Roth IRA is one type of account that can be used if you choose to move from a 401(k), although there are many moving parts and potential tax consequences. A Roth IRA uses after-tax money that can grow tax-deferred and then can be withdrawn tax-free. It can also be passed on to heirs tax-free as long you follow IRS guidelines. Be aware, however, that money moved from a 401(k) to a Roth will be taxed at ordinary income tax rates. Please consult a financial advisor and tax professional before implementing tax-reducing strategies. While this strategy isn’t for everyone, it can be a powerful tax-reducing tool.

Another type of IRA account is an annuity from an insurance company. Annuities may be useful for some investors who want guaranteed monthly cash flow through retirement. Annuities can also be used for portfolio diversification, where investors are trying to minimize downside risk and also want to participate in market growth that may outpace inflation. Vanilla annuities used for asset protection can be very low cost. Run from anyone who believes annuities never work or always work, as almost all financial products have pros and cons.

#5 - INCOME PLANNING FLEXIBILITY

As you approach retirement and assess your income needs, generally the place to start is sitting down and making Social Security decisions. These decisions shouldn’t be made in a bubble, but rather should take into account all your assets, including your 401(k) and IRA assets. Firms like mine (Thrive Retirement Planning) can help you determine your Social Security claiming strategy that integrates all the moving parts of your retirement income plan. Fiduciary financial planners such as Thrive Retirement Planning can help you make some of these more critical retirement decisions.

Once you determine your Social Security income, you can then determine your income gap and make income plans around pulling from your other assets to create retirement cash flow that covers your retirement expenses and also minimizes your risk of running out of money.

As a reminder, one of the most important rules with a 401(k) or IRA is knowing that after 59 ½ withdrawals will be taxed at ordinary income tax rates. Uncle Sam is your partner during retirement and he can adjust the percentage he gets from your retirement pie. If you withdraw money before 59 ½, you’ll often pay a 10% penalty.

When investors start withdrawals from their 401(k)s or IRAs during retirement to fill in their income gap beyond Social Security, an IRA has additional features that aren’t available in a 401(k). To illustrate, in a 401(k) you can’t select individual investments to be sold to generate cash for your income. As a comparison, you can easily select the positions you want to sell to liquidate your investments in an IRA, especially if you’ve selected investments with income planning in mind. While this may seem like only a small difference, this can have a significant impact on the performance of a portfolio over time.

WHEN MOVING FROM A 401(K) TO AN IRA MIGHT NOT MAKE SENSE

As with all financial strategies and products, there are pros and cons. There are some instances when staying with your 401(k) may make sense. I’m not going to go in depth in any of these areas but want to make you aware so you can talk with your financial advisor or do more research about these.

High appreciated company stock – if you own highly appreciated company stock you may want to look at a NUA (Net Unrealized Appreciation) strategy that may provide tax savings. With a NUA you’ll use a brokerage account instead of an IRA for the company stock.
Legal protection – a 401(k) is protected against most types of creditor judgements. If you are worried about potential judgements, creditors, or collections, keeping your money in your 401(k) may be the best option.
The Rule of 55 – This rule allows an employee who has been laid off, quits, or is fired to access their 401(k) before 59 ½ without the 10% penalty. You will still have to pay ordinary income tax on the withdrawals of course. This waiver of the 10% penalty doesn’t apply with an IRA.

ACTION STEPS

If you have a 401(k) with a company you no longer work for, consider simplifying your investments and moving it to your current 401(k) or an IRA. Also, if you’re close to retirement, you may want to take a serious look at converting to an IRA for additional investment flexibility, tax minimization, and comprehensive retirement planning services.

Take a look at working with a comprehensive fiduciary advisor who can help you with Social Security claiming strategies, creating an income plan, and reducing your taxes through proactive planning. These differences can add more than $100,000 to some retirement plans.

Do you want to work with a firm committed to not only help to achieve your goals financially but also with your family and fulfillment? You can set up an appointment by calling 801-810-8434. Do you have questions about when to take Social Security and how to maximize your benefit? Take our free online Social Security Masterclass.