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While the advantages of rolling over a 401(k) are well documented, it’s always a good idea to consider the other half of the equation. It’s certainly true that moving an old 401(k) to a new IRA (Individual Retirement Account) has its upside: consolidation, lower fees, more control, and usually more investment options. However, like with almost anything in personal finance, there’s rarely ever a perfect solution.
Here, we’ll explore the disadvantages of rolling over an old 401(k) to an IRA.
There are a number of circumstances that may make rolling over your 401(k) less than ideal:
While many 401(k)s have higher fees than IRAs, that’s not always the case. If you’re satisfied with the investment choices offered, keeping your retirement savings in your old employer’s 401(k) plan may be just fine. (Note: You can’t roll an active 401(k) at your current employer into an IRA.)
Money in a 401(k) benefits from the “Rule of 55”, which allows you to make qualified distributions from your 401(k) plan without early withdrawal penalties as long as you’re age 55 and retired. While this won’t eliminate the tax hit when you do withdraw the money, you’ll be able to take advantage of this Rule with your 401(k) — but not with your IRA.
Unless you’re starting with a Roth 401(k), rolling a traditional 401(k) to a Roth IRA can result in a five- or six-figure tax bill depending on your total balance. While tax-free retirement income and no required minimum distributions are nice perks, it may still not be worth the price of a Roth IRA conversion. If your circumstances call for such a rollover (it’s rare), be sure to speak with a tax advisor first.
401(k)s, relative to IRAs, tend to be more protected from a legal standpoint. Should you ever need to file bankruptcy, the 401(k) is preferred to your IRA in terms of keeping all your assets, helping you avoid what’s known as loss of creditor protection.
When you have a 401(k), you can sidestep the “pro-rata rule”, which has to do with converting pre-tax IRAs to Roth IRAs. If Roth conversions are in your future (as they would be if you use “backdoor Roth” conversions), keeping the 401(k) is a stealthy way to reduce your tax on conversion. (Note: This is an advanced financial planning topic., so if it doesn’t make sense to you, don’t worry too much about it.)
Try to be careful around retirement account rollovers, as they can often result in unintended tax consequences. Make sure to think through any rollover activity before you begin one — it’s worth the extra time!
First, it’s important to remember the difference between a penalty and a tax consequence. Penalties are levied when you do something that you’re “not allowed” to do; taxes are imposed when you declare money as current-year income (which can happen whether you meant to do it or not!). So one of the main goals when rolling over a 401(k) is to avoid both taxes and penalties, which is both achievable and not too difficult if you’re careful.
Next, there’s also a big difference between rolling over money and withdrawing it. Usually, rollovers do not result in penalties, but withdrawing money from your retirement plan early most certainly can. Rollovers may result in taxes charged, but this can be avoided with some diligent planning. On the other hand, withdrawals will almost always carry an early withdrawal penalty unless the money is coming from a Roth 401(k).
So the short answer is yes, you can roll a 401(k) into an IRA without penalty — as long as you roll your 401(k) into a “like-tax” IRA. To avoid tax, you’ll need to ensure you roll your pre-tax 401(k) into a pre-tax IRA (typically referred to as a traditional IRA, sometimes a Rollover IRA).
One rollover activity that would cause a tax hit is if you were to try to roll a pre-tax 401(k) to a Roth IRA. Because these accounts are not “like-tax” — the 401(k) is pre-tax and the Roth IRA is post-tax — you’ll be liable for ordinary income tax on the entire amount rolled over. This is a prime example of why due care is needed when attempting any rollover.
The next thing to understand — and which could bite you if you’re not careful — is that not all rollover options are equal.
When you choose to move your retirement assets to a new account, you can choose between a direct rollover and an indirect rollover. But if you choose the latter, you could face unintended tax consequences.
That’s because, unlike with a direct rollover, where the money goes to the new financial institution without ever landing in your hands, an indirect rollover means the old custodian will cut you a check for the money, which you then have to reinvest with your new provider.
However, there’s a serious catch: In most cases, your old plan sponsor will be required to withhold 20% of the total for taxes. You’ll see it later as a tax credit, but in the meantime, you’re on the hook to reinvest the entire amount — making up the 20% out of your own pocket — to avoid paying an early withdrawal penalty and yet more taxes.
That’s why direct rollovers are almost always the best choice, regardless of your plan administrator.
The unique tax advantages of Roth retirement accounts make them particularly attractive, but as we mentioned above, the price you’ll pay to access them may not be worth it. Roth conversions on large amounts of money, like the amount that may be in your retirement savings, can have tax bills on the order of an annual salary. You’ll almost certainly want a financial advisor to help you go through a Roth IRA conversion, which is another expense.
There are, however, some situations in which converting your retirement assets from traditional to Roth makes sense. For instance, if you’re in a year where you’ll have a substantially lower tax bracket than normal, it might be a good time to tackle the conversion since you’ll pay less federal income tax overall.
Additionally, if you’re fairly certain you’ll be in a higher tax bracket come retirement time, paying the income taxes now might be worth it for free withdrawals in retirement time. Still, get a qualified tax advisor on your side and make sure you understand the tax implications before you pull the trigger, because they can be significant.
While many investors choose to roll their retirement assets over to an IRA to access more investment options, the truth is, unless you’re a skilled trader, the mutual fund options available with your 401(k) provider are likely sufficient. Many of these plans offer target-date funds that you can choose based on when you’re planning to retire, making the whole process simple and user-friendly.
It is worthwhile, however, to consider the investment fees for each provider, because IRAs do often have lower fees than 401(k)s. This isn’t always the case, though, and if you’re moving on to a new employer, you could see if their new plan offers a lower-fee 401(k) option.
Generally, no. Although there could be some minimal loss if you were to roll money over and the stock market were to rise generously when the rollover was “in transit” between accounts.
When you roll over your 401(k), you liquidate (sell) all of the investments in the account. This effectively takes you out of the market.
When the rollover arrives into your new IRA, it will arrive in the form of cash, and it will be up to you to invest it. The time between the sale of your old investments and the purchase of your new ones could result in some loss of market growth, but it could also result in a gain if the market falls during this 1-2 week period.
You also can “lose money” in the form of taxes, but this is avoidable as previously mentioned.
When you think about a carefully planned 401(k) rollover, there is really no reason to be concerned about losing money.
