Rollover rethink: 4 good reasons not to roll 401(k) funds into an IRA

It seems that just about every financial company pitches the benefits of rolling your 401(k) plan into an individual retirement account, or IRA, after leaving your former employer. Clearly, there are many situations where this could be beneficial.

But there are many other times when it may be best to keep the 401(k) intact and not transfer the funds to an IRA.

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Here are four situations when it may be best to keep the 401(k) with your previous employer:

1. You are between ages 55 and 59½. By now, most of us know that we must be at least 59½ before we can take money out of a retirement plan and not get hit with penalties. If we withdraw money before that age, we get slapped with a 10 percent early withdrawal penalty. (One exception to this rule is separation from service.)

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If you are at least 55 years old when you leave your employer or will turn 55 sometime in that calendar year, you can access your 401(k) without early withdrawal penalties. You don't have to wait until age 59½, and you can pull money from the plan as many times as the employer's plan allows (typically, several withdrawals per year).

Once the 401(k) is transferred to an IRA, the age 55 rule is eliminated and withdrawals are restricted until age 59½.

Oftentimes, people will roll their 401(k) to an IRA without even knowing about this rule. Many financial advisors will neglect to mention this to their clients, because they have a financial incentive to receive commissions from an IRA that they can manage rather than leaving the money in the 401(k).

Keep in mind that this separation-from-service rule applies only to the retirement plans from the employer you leave after age 55. It does not apply to other 401(k) plans that may exist from previous employers.

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2. Your plan consists of highly appreciated employer stock. For many of us, the majority of our 401(k) plans are invested in funds and stable value accounts. But for some, a large portion of their 401(k) funds is invested in their employer's stock.

A great tax-planning opportunity known as Net Unrealized Appreciation (NUA) exists for those who have a significant amount of company stock within their 401(k). NUA works like this: Suppose you paid $5,000 for your employer's stock and now the value has risen to $20,000.

Rather than roll the stock into an IRA, you choose to have the shares sent directly to you or your brokerage account. In this scenario, you would incur taxes on a $5,000 retirement distribution, but you wouldn't be taxed on the gain until you sold the stock. If and when the stock is eventually sold, the gains would be treated as capital gains rather than ordinary income.

There are a number of things to keep in mind before utilizing the NUA strategy: First, many 401(k) plans don't enable an employee to purchase their stock; rather, the plans have a "fund" that mimics the performance of the stock. It's very important to verify that your plan provides actual company stock.

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Second, having stock distributed rather than rolled over to an IRA can result in a hefty tax bill. A large distribution could push you into such high tax rates that the current taxes would offset any savings that NUA could offer.

Careful planning is necessary when evaluating this technique, but it can work wonders in the right situations.

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3. Your 401(k) plan has adequate options. Many people complain that their 401(k) doesn't provide enough investment options. If you are lucky enough to have a plan with plenty of good options and you are adept at picking and managing your investments, it may be best to leave the money in the original plan.

A 401(k) often can access institutional pricing that everyday investors cannot, which results in fees that may be lower than a similar portfolio constructed within an IRA.

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4. You could benefit from help but don't know a good financial advisor. Some people are great at managing their 401(k) and wouldn't benefit from hiring a financial advisor. But it's been my experience that most people would benefit from having some help with their retirement investing.

The challenge that I've seen is that for many, it's hard to tell the good financial advisors from the not-so-good ones. If you don't already have a relationship with a good advisor, you may be sold an IRA that contains expensive investments that may not perform as well as your 401(k).

"A target-date fund would certainly be a better option than rolling your 401(k) balance into a lousy financial advisor's IRA."

Most 401(k) plans these days contain target-date funds. These are funds that are designed to be more aggressive while you are younger but become more conservative as you get closer to your retirement age.

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While using these funds may not be a perfect strategy, for many they can work just fine. A target-date fund would certainly be a better option than rolling your 401(k) balance into a lousy financial advisor's IRA.

There are many good reasons to roll a 401(k) to an IRA, and most investment firms will spell out those benefits. Just keep in mind that there are times when it may be of greater benefit to keep the 401(k) intact.

—By Scott Hanson, special to Scott Hanson, a certified financial planner, is a senior partner at Hanson McClain Advisors.