Americans have a significant part of their retirement savings in defined contribution plans. Think 401(k)s and 403(b)s. And there are tens of millions of participants in those plans. And they hold approximately seven TRILLION dollars. At some point, when people have separated from their employer, many of those people will ask themselves, “Should I roll this over to an IRA or leave it where it is?”
That’s a great question, one which many people struggle with. The short answer is, “It depends.” There are a range of issues you might consider: What are the fees in an IRA versus my plan? Do I want or need a better selection of investment options? How important is it that I have the most control of my assets? You should also consider whether having an advisor for your assets may be helpful outside the plan. All things to consider, but I would submit there is another important set of considerations you should think about, but that most people don’t.
What many people miss on this topic is what rules the 401(k)/403(b) plan and the IRS have when you leave your money in the plan.
First, what are the withdrawals available? Believe it or not, many plans (my rough estimate is between 30 and 40 percent) allow a full payout only. This means if you want anything, everything must leave the plan. This surprises many people, and clearly limits how useful the plan might be to you. Other plans will only allow a certain number of withdrawals per year, which again crimps flexibility. Furthermore, you are required to have 20 percent minimum withholding in federal taxes on withdrawals, regardless of what tax bracket you are in, which could create an over-withholding in taxes. This last point does not apply to required minimum distributions (RMDs), only ordinary withdrawals.
Regarding RMDs,which start at age 70.5, if you want to take that from a specific fund in your plan, it may or may not allow that. Most do not. Some plans also do not send RMDs, automatically so if you aren’t on your toes you could forget and be subject to a 50 percent penalty from the IRS. No one wants that, but it happens.
You also can’t aggregate RMDs (take all your RMD obligations) from one plan if you have several. Each one must make a distribution. This irritates a lot of people.
And then there’s this: How are your beneficiaries treated? Many people mistakenly think that by naming their spouse they have addressed this issue, but they may miss a very important point. If your spouse inherits your plan, a few things can go wrong. First, while infrequent, a plan’s rules can elect to pay the account assets out, fully taxable, if it is not rolled over or otherwise removed from the plan within a certain timeframe. Secondly, if your spouse inherits the account and if you have started RMDs, then the calculation that applies to that RMD will create a distribution approximately 40 percent bigger. This is due to the fact the IRS calculates the RMD differently for beneficiaries using a table called the single life table.The upshot? A much bigger taxable distribution. So if spouses may not need the RMD, they will be required to take an even bigger RMD whether they like it or not. This creates excess taxes, and speeds up the drawdown of the account. And if your beneficiary is nonspousal (think kids or siblings), the rules can be murkier still and are generally less accommodating than for spouses.
And finally, what happens to your spouse if you die? While you may have been confident and competent to handle your account, your spouse may not be. This situation is more often perilous when the inheriting spouse is a novice, and has no real knowledge of what they should do. This makes them very vulnerable to people without their best interest at heart. They can end up with expensive, complicated, or illiquid investment products, which can cause a lot of financial chaos. Having a trusted advisor you are already working with for an IRA will make that transition more comforting and easy for a surviving spouse.
So by rolling over your account, the issues mentioned here now go away. But again, it depends what is most important to you and your loved ones.
Many people think, “But my plan has low costs.” While the popular assumption is that a plan will have lower-cost investment options, expenses in IRAs can frequently be lower than in plans. This is due to the significant pressure on pricing in mutual funds and ETFs that we have seen over the past several years, which is expected to continue. But if you do choose to use an advisor to help with an IRA, you should still be wary of being sold inappropriate products. Studiously avoid complex and costly annuities, or any other products that you don’t understand. Keep it simple and low-cost.
When deciding whether or not to roll over your plan, there are many things to think about. When pondering that question, make sure you understand all the implications and rules that the plan and the IRS have for your assets when they stay in your old 401(k). These plans are great for saving money, but they might be a bad place for your money when you need it or when you die.
John Kageleiry is a business writer and financial planner. Have a question for “Finance 101”? Email it to firstname.lastname@example.org.