Many retirement savers who are changing jobs transfer funds directly from their previous employer's 401(k) into their new employer's retirement plan, starting and finishing the process with a quick phone call to the new plan administrator. That's not always the best move, financial advisors say.
"There's no real blanket answer for every situation," said Altair Gobo, a certified financial planner and partner with U.S. Financial Services. "You have to look at the individual person and come up with the right solution."
Here are six options that would-be rollover Jedis may want to keep in mind for their individual situations.
1. Roll over into a new individual retirement account. Transferring funds from a previous 401(k) into a new IRA preserves the most investing flexibility, advisors say. Company plans may limit options to a handful of mutual funds. An IRA lets an investor choose nearly anything, from bank certificates of deposit to real estate.
On the downside, a 401(k) tends to have lower costs than an IRA. "You probably have an advisor to the plan who's basing the fees on a plan that has millions or tens of millions of dollars," said Joseph Heider, a Chartered Financial Consultant and president of Cirrus Wealth Management. "So the investment costs and fees are generally lower."
A major advantage a 401(k) has is that, as long as the account holder is still employed, he or she can borrow from it. Being able to tap retirement funds without paying the penalties and taxes levied on preretirement withdrawals is a potent benefit when deciding whether to roll funds out of a 401(k) and into an IRA, according to U.S. Financial Services' Gobo. "The biggest reason for leaving it there would be the ability to borrow from the plan," he said.
2. Leave funds in a former employer's plan. Sometimes it is best to leave retirement funds in a former employer's plan rather than transfer them to a new employer's plan. For example, the old plan may have lower investment costs or better investment choices than the new employer plan.
"You want to look at the plan summaries to see which has the lower fees," said Daryl Dagit, a CFP and financial advisor with Savant Capital Management. A plan summary will also describe the investment choices available.
Staying in a former employer's plan is not always an option. If an account has less than $1,000, custodians can force an account holder to leave. "They can write the check and send it to you," Dagit said. "Then you owe not only the tax but a penalty if you're under age 59½."
3. Transfer to a new company plan. Transferring 401(k) funds to a new company-sponsored retirement plan can be smarter than leaving them where they are if the new plan has more investment choices or lower fees. And it may be smarter than transferring to a new IRA, because of advantages a 401(k) has over an IRA.
The ability to borrow against account funds is just one advantage 401(k) plans hold. Savers who have reached age 55 and stopped working can withdraw 401(k) funds without having to pay the 10 percent penalty otherwise levied on early IRA withdrawals.
"It may be best for you to stay in a 401(k) even if your investment options are limited or costly if you want to retire before age 59½," said Jonathon Jordan, CFP and vice president with Walkner Condon Financial Advisors. "That's the age you can take withdrawals from an IRA.
"But with a 401(k), it's 55."
4. Do an in-plan Roth conversion. Sometimes the right approach is to do an in-plan 401(k) Roth conversion. Some plans allow for transferring all or a portion of a 401(k) plan's funds into a Roth account within the same plan. This can save on taxes long-term, as future Roth 401(k) distributions won't be subject to taxes.
"If you feel you're in a lower tax bracket than you will be in retirement, then the Roth conversion makes sense," Savant's Dagit said. "If you'll be in a lower tax bracket in retirement, it may make sense to do the Roth conversion once you retire."
The downside of an in-plan Roth conversion is that the account holder must pay income taxes on the amount converted. Cirrus Wealth's Heider says that makes the account holder's age another key consideration.
A 30-year-old can pay taxes on a Roth conversion and then watch the remainder grow tax-free until retirement, Heider notes. "That's a tremendous benefit," he said. "On the other hand, if I'm 65 and convert to a Roth, pay the tax and start withdrawing it in a couple of years, I'd argue that makes no sense unless you're in a nearly zero percent bracket."
5. Withdraw funds and convert to a new Roth IRA. Taking money from an ex-employer's retirement account and using it to fund a new Roth IRA outside the plan can, like a transfer to a new IRA, increase investment flexibility over an in-plan conversion. And compared to a similarly flexible IRA, an out-of-plan Roth offers appealing long-term estate planning benefits.
"It's a nice way to transfer wealth to your kids," said Walkner Condon's Jordan. A big advantage is that heirs won't pay taxes on Roth funds as they would with IRA funds. The primary disadvantage is the same as with an in-plan Roth — taxes have to be paid now.
6. Take a lump-sum conversion and pay tax. Advisors rarely recommend taking a 401(k) distribution as a lump sum, paying tax on it and placing it in a regular brokerage account. However, this may be a good move if the plan contains employer stock. When transferred from a tax-advantaged account, the difference between the shares' current value and their average cost — the net unrealized appreciation — may be taxed as capital gains rather than ordinary income, Jordan explains.
Getting net unrealized appreciation treatment for highly appreciated shares can save lots on taxes, since the capital gains rate is generally lower than ordinary income tax. But savers may still have significant taxes due and also need good records showing prices at which shares were acquired. "This is one that takes careful planning," Jordan said.
People leaving a job may reactively transfer funds from an old plan to a new IRA or employer plan, Cirrus' Heider says. But following that impulse can be a costly mistake.
"Particularly if something comes up that's unexpected, such as you're fired or laid off, don't feel pressured," Heider said. "Take a little bit of time, get over the emotion of the moment, and sit back and look at all your options."