Financial planning aspects of 401(k) rollovers
July 19, 2023
By Kelley C. Long, CPA/PFS
With workers changing jobs on average about every four years, according to the most recent U.S. Bureau of Labor Statistics numbers, it's no wonder that many people accumulate multiple Sec. 401(k) accounts, some of them potentially languishing due to inattention and incurring unnecessary fees.
Common reasons people don't roll over 401(k) accounts when switching jobs is confusion over which rollover option is best and a lack of urgency when fund balances are seen as insignificant.
The Department of Labor's "rollover rule" requires financial advisers to provide specific documentation showing that a rollover of a retirement account to the adviser is in the client's best interest. While the rule has been challenged in court with partial success, advisers should be aware of the new requirements and can expect some type of additional scrutiny of recommendations around moving retirement assets in the future.
Because of the varying features of 401(k) plans and IRA products, along with certain rules around early distributions, the decision to roll over or leave the funds in place will depend on each client's situation. This article reviews the options and how to support clients in deciding. Those options are:
- Leaving the account with the prior employer;
- Rolling the account to the client's current 401(k) or 403(b) account;
- Transferring it to a rollover IRA; or
- Distributing the account, which is the least desirable option unless the client is in significant financial distress or has a specific reason for doing so that considers the tax consequences.
In support of leaving the account with the prior employer
On the surface, leaving a retirement account with a prior company might seem unwise, particularly where the employer elects to begin charging account administration fees to former employee accounts. This often goes unnoticed by clients due to lack of attention to account statements and can erode account assets unnecessarily. However, in the absence of such fees or when the fees are negligible, there are two compelling reasons it might make sense to leave the account in place.
The 'Rule of 55': One potential reason not to roll over the funds is what's known as the Rule of 55. Under this rule (Sec. 72(t)(2)(A)(v)), after people separate from service with an employer in or after the year they reach age 55 and then take a distribution from certain employer-sponsored qualified retirement plans including 401(k)s and 403(b)s, no 10% early withdrawal penalty applies. Essentially, if the client is age 55 or older and wishes to access 401(k) funds prior to age 59½, it may make sense to keep the account with their last employer in order to make penalty-free withdrawals, rather than roll it over to an IRA.
Unique investment options: The other situation in which there may be good reason to leave a retirement account with a prior company is when the account holds employer stock or, in rare cases, when unique investing options are available only within that particular plan.
In the case where a client owns highly appreciated stock in the employer company, before taking any distribution of plan funds, the client should determine whether they wish to take advantage of the net unrealized appreciation (NUA) rules. Those rules allow a lump-sum distribution of company stock with taxation of only the stock's original cost basis rather than the entire value. Any growth of the stock is taxed at capital gains rates and only upon sale of the stock outside the retirement plan. However, a taxpayer can elect not to have this rule apply and include the net unrealized appreciation included in employer securities in income in the year of distribution.
In rare cases where the former employer plan includes unique investment options available only to participants in the firm's retirement plan, clients may wish to leave at least some assets in that plan as part of a broader diversification strategy. Beware, however, of clients' perceiving their prior 401(k) investments to be superior simply because that account outperforms other investments the client holds, typically due to differing asset allocation or investment timing, rather than a significant difference in investment choices.
In support of rolling the account to the client's current 401(k)
If the client has moved on to a new job that offers a 401(k) or 403(b) benefit, it often makes sense to combine the accounts and keep all employment-based retirement assets together. This provides simplicity and ease of record-keeping in addition to a few other potential benefits, which depend on the specific employer's plan. These include:
Increasing the ability to borrow: One advantage of rolling the funds to the current employer plan is, since most 401(k) and 403(b) plans offer participants the option to borrow from their accounts, combining accounts with the new employer plan may increase the amount available for plan loans if needed. The pitfalls of borrowing against retirement assets should be discussed, but in cases such as refinancing high-interest-rate debt, it can make sense, as long as the client has addressed the cause of the original debt.
The Rule of 55: As discussed above, this rule may make it desirable to keep the funds in the old employer plan rather than roll them over to an IRA. If the client has found a new job and wishes to take advantage of the Rule of 55, however, it's a good idea to roll all accounts to the current employer. This is because the early withdrawal penalty exception only applies to the retirement plan of the most recent employer, even if assets in that plan were accumulated at prior companies.
Back-door Roth contributions and account aggregation: Another situation in which it may make sense to roll the funds to the current employer plan involves back-door Roth contributions. If the client's income exceeds Roth IRA contribution limits and the client wishes to utilize the back-door Roth strategy, then keeping any pre-tax retirement money in an employer plan helps to avoid the account aggregation rules when performing Roth IRA conversions. This prevents the unintended taxation of traditional IRA assets that often catches first-time users of this strategy by surprise at tax time.
Investment fees: Another potential reason to roll the funds to the current employer plan involves investment fees. Prior to ERISA and the resulting lawsuits around excessive fees in employer-sponsored retirement plans, the fee argument leaned strongly in favor of clients transferring 401(k) assets to an IRA, where fees could be much more transparent, such as when an adviser charges a straight 1% assets-under-management fee.
These days, particularly for larger employer plans, fund expense ratios are likely to be lower in a 401(k) plan than the client would pay using similar investment options in an IRA. Many employer-sponsored plans offer low-cost institutional share class mutual funds and index funds, which are generally less expensive to own than what's available in individual accounts. Checking the expense ratio of available funds in the new employer's plan can help determine if this is the case.
Administration fees are another area to consider, as this can skew the total fee in favor of an IRA, particularly if the participant would otherwise be using a low or no-cost provider where the only fees are within mutual funds. Again, the larger the 401(k) plan, the lower these administrative fees are likely to be, at least as long as the participant is actively employed, but this is worth exploring if fees are a key consideration.
In support of moving the funds to a rollover IRA
If the client doesn't have a new employer plan available or wishes to be more involved in the investment management of their funds, then a rollover IRA often makes sense. Other financial planning strategies are available for IRA funds that aren't as accessible when savings are held in employer-sponsored plans. Here are some reasons for rolling the account to an IRA:
Broader investment options: The most common consideration in favor of moving funds to a rollover IRA is the client's ability to choose from the entire world of retail investment options rather than being limited to the employer's plan options. For clients who wish to invest in individual stocks or who have a particular affinity to specific fund families or other asset classes, this is a key reason to perform a 401(k) rollover to an IRA with the provider of their choice.
Strategic Roth conversions: A rollover to an IRA may also be desirable where the client's current 401(k) plan doesn't allow in-plan Roth conversions for any pre-tax funds inside the account. In that situation, it can make sense to roll pre-tax funds to a traditional rollover IRA so the client can perform tax planning through strategic Roth IRA conversions.
Accessing funds before age 59½: Another potential reason to roll the funds into an IRA is to make it possible to access them early to pay for educational expenses or a first-time home purchase or to use as a backup emergency fund. While it's generally a best practice to keep funds invested in a retirement account for their primary purpose of funding the client's retirement lifestyle, there are financial planning strategies where it may make more sense to tap retirement assets, even temporarily through the 60-day indirect rollover rule. This is frequently only possible to do when the funds are in an IRA versus an employer-sponsored plan, where the early distribution rules for active employees are often more limited and involve additional documentation to access funds. (See "3 Strategic Uses for Roth IRAs Beyond Retirement," JofA, Aug. 2, 2022.)
When accounts with smaller balances are automatically cashed out
It's also worth noting that the rules allow employers to automatically cash out accounts with balances under $1,000 60 days after termination, which can lead to surprise taxation when the client doesn't realize they could have deposited the funds into a rollover IRA within 60 days to avoid full taxation and the early withdrawal penalty.
For balances between $1,000 and $5,000, the employer is allowed to automatically perform a rollover to an IRA with the provider of the employer's choice, which can make it more difficult for clients to locate old retirement plan assets if it has been a while. Should a client discover an account that was an automatic rollover that they, in hindsight, would have preferred to transfer to their new 401(k), most plans allow active participants to transfer rollover IRA money into the plan, as long as the client can document that the assets were always classified as retirement savings.
What it really comes down to
It's important to be aware of all factors involved when deciding what to do with old employer retirement savings, but for most clients, the decision likely comes down to two key factors:
- Which option has the best fees and investment options?
- How important is it to keep all savings in one place versus managing multiple accounts?
Kelley C. Long, CPA/PFS, CFP, is a personal finance coach and consultant in Arizona.