This is a common question posed by clients to financial advisors. I honestly couldn’t tell you how many times I’ve discussed this issue with clients, but it’s definitely one of the most common concerns of new retirees.
An IRA rollover is often an irrevocable decision. Please go into the choice fully informed. Here are some factors (in order of importance) that I like to think about when making this decision:
Investment costs and advisory fees
This is easily the most important factor. If your 401(k) or other qualified retirement plan is run by a large, efficient organization, then it’s likely the plan has low costs and reasonable fees. However, even this day in age, there are many 401(k) plans with very high fees. If your 401(k) plan has high fees, then switching to an IRA could make sense.
However, if you’re working with a financial advisor, then it’s important to consider any marginal advisory fees. For instance, if your financial advisor charges the typical 1%-of-assets on your IRA assets, but not on your 401(k) assets, then your advisor has an obvious conflict of interest and you’ll want to take a closer look.
Small business owners (i.e. plan sponsors)
If you own a small business with a 401(k) plan for the employees, then it’s likely that you’ll want to terminate the plan upon your retirement to avoid the significant costs around 401(k) administration. At that point, you generally must execute an IRA rollover.
Consolidation/Simplification (+ RMD tracking)
Some people might put consolidation considerations down further on this list, but I’m a huge fan of simplifying and consolidating accounts. I just believe that many people massively underweight the benefits of a simplified financial life.
I once worked with a client who had 35+ accounts spread across about six separate custodians, including about ten old 401(k) accounts. Fortunately, we were able to consolidate all of these accounts down to three (joint account + 2 IRAs), all at a single custodian. When everything was said and done, the client was thrilled! Way less administrative hassle.
When it comes to tracking RMDs, 401(k) accounts each require a separate distribution. For IRAs, you can take a single RMD to cover all of your IRAs. Generally, the fewer RMDs you need to keep track of, the better.
Tax planning
There are a host of tax planning considerations when it comes to IRA rollovers. For order of importance purposes, I’ll treat them as a single unit.
- Backdoor Roth IRA contributions – if you plan to continue working and your AGI is too high for direct Roth IRA contributions, then an IRA rollover will make it much more difficult to execute a backdoor Roth IRA.
- Removing after-tax basis from an existing IRA – if you have after-tax basis in your IRA, then it can sometimes make sense to go in the other direction and do what’s known as a “reverse rollover”. In this case, you transfer pre-tax IRA assets into the 401(k) plan (if the plan rules allow). The remaining funds in your IRA will be after-tax dollars, which you can then convert to a Roth IRA with minimal tax issues.
- Delay an RMD on the 401(k) assets – this applies to individuals who are still working + over RMD age + less than 5% owner of the employer. If you want to delay your RMD, skip the IRA rollover.
- Tax withholding flexibility – taxable 401(k) distributions have a mandatory 20% tax withholding. IRAs do not.
- Qualified Charitable Distributions (QCDs) – only IRAs are eligible for QCD treatment.
- Beneficiary Roth Conversions – qualified retirement plans allow you to convert non-spouse inherited assets to an inherited Roth IRA. Can’t do that with an IRA.
- Tax efficient payment of advisory fees – if your financial advisor charges an advisory fee on your 401(k), then you almost certainly have to pay those fees from a separate account (such as a taxable brokerage account). An IRA rollover would allow your advisor to deduct the portion of the advisory fee attributable to your pre-tax IRA from that account. In essence, you can likely pay a (larger) portion of your after-tax advisor’s bill with pre-tax dollars if you execute an IRA rollover.
- Net unrealized appreciation (NUA) – individuals who own low-basis employer stock in their 401(k) can take advantage of NUA tax treatment.
Liquidity planning
Your liquidity needs will also affect the IRA rollover decision.
- Plan loans – in many cases, you can borrow from your 401(k) plan. You can’t borrow from an IRA except with a 60-day rollover.
- Early withdrawals – if you need funds prior to age 59.5, then you’ll likely want to avoid early withdrawal penalties. If you plan to separate from service with your employer after age 55 (or 50 in some cases) and don’t want to use rule 72(t), then your qualified retirement plan likely offers better liquidity. But if you need the funds for higher education expenses, a first-time home purchase, or some health insurance premiums, then an IRA rollover can offer additional liquidity.
- Payout options – some qualified plans require a 10-year payout period. IRAs do not.
Quality of investment options
Most 401(k) plans offer a pre-determined “menu” of investment options. The investment options in an IRA are generally much more flexible. However, there can sometimes be workarounds. Many large 401(k) plans offer a “brokerage window” option, where you can invest your 401(k) plan assets just like you would inside an IRA.
Creditor protection
All else equal, qualified retirement plans covered by ERISA can offer a bit better creditor protection. Many folks focus on this factor to the exclusion of all the others. However, if you have sufficient liability insurance coverage, I would argue this a fairly minor factor. If creditor protection is a top concern, then consider talking with an attorney about your options in tandem with the IRA rollover decision.
Spousal beneficiary choice
If you are married, then you need your spouse’s permission to name someone else as primary beneficiary on your 401(k) account. IRA beneficiaries can be changed without approval.
Which is better?
At the end of the day, the choice of whether or not to execute an IRA rollover will depend on your personal circumstances. As I mentioned earlier, the key factor for most people is the difference in fees. For flat fee advisors like me, our fee generally doesn’t change when clients decide to execute an IRA rollover (or not). As a result, I like to believe that I provide a viewpoint with less bias than the average financial advisor.
But be sure to review all of the above factors before making a decision! For some people, even minor factors can have a big impact on the success of an IRA rollover.
Thanks for reading!
