Do you have an old 401(k) retirement plan at a former employer? Lots of people do and they invariably are faced with not knowing what to do with it after they have left the company. Since this question comes up a lot, I wanted to address it here.
If you have an old 401k balance at a previous employer and are wondering, “should i roll my 401k into an IRA” (Indvidual Retirement Account: Traditional or Roth), my answer is generally “Always convert a 401(k) to an IRA“.
The benefits to convert a 401(k) to an IRA far outweigh the reasons you should not. Ultimately each situation is different, so consult with your trusted advisor to guide you accordingly. If you don’t have one, you should consult with one. Nevertheless, here are my reasons why:
Reasons to Convert a 401(k) to an IRA
Investment Control – With an IRA, thousands of investment choices are available to you: stocks, bonds, mutual funds, ETF’s, REITs, and alternative investments like physical gold and silver. The average 401(k) plan only offers a small selection of about 15-20 mutual funds and possibly company stock. You can even actively trade the account and any gains would be tax deferred (taxed when you make a distribution). If you roll a 401(k) to an IRA, you basically are going from limited investment options to an unlimited number of investment opportunities. Keep in mind that diversification is the key to investment success.
Lower Fees – Many 401(k) plans have high fees and limited investment choices. If you decide to convert your 401k to an IRA, you can purchase mutual funds that have no sales charge and with very low management fees.
Beneficiaries – An IRA generally allows you to name anyone you want as a beneficiary. If you’re married, your spouse is automatically the beneficiary of your 401(k). If you want to change this to someone other than your spouse, your spouse must agree and sign a waiver.
Avoiding Tax Problems – If you mistakenly withdraw 401(k) funds in your own name (and this does happen more often than you would think), you will owe ordinary income taxes and an additional 10 percent penalty unless you qualify for an exemption. Also, if you convert a 401(k) to an IRA, a former employee does not have to worry about withholding taxes or penalties to the IRS due to an early distribution.
Compounding Interest – A self directed IRA is the perfect vehicle to allow your money to grow. A rollover IRA can continue to grow due to compounding interest as long as the money is invested properly.
Reasons to NOT Roll a 401(k) into an IRA
Creditors – IRA’s are not safe from creditor protection in certain situations, namely in non-bankruptcy default situations. In other words, under the right circumstance a creditor could go after your IRA, but cannot for a 401(k).
Retiring 55-59 – If you stop working at age 55 or later, you can take penalty-free withdrawals from the 401(k) plan associated with the job you most recently left. There is generally a 10% penalty if you make a withdrawal from a 401(k) or IRA before age 59 ½.
Company Stock – If you own company stock in your 401(k) plan, keep in mind that it gets special tax treatment when it’s held in a 401(k). If this is the case for you, this is something to keep in mind.
Low Fees – A few companies are able to use their bargaining power to negotiate low fees and offer good investment options. If this is your situation, then you may not want to convert a 401(k) to an IRA.
Still wondering… “Should I Roll my 401k into an IRA?”
The answer is ultimately up to you. You should speak with your accountant or CPA to discuss your specific situation. The benefit of rolling a 401(k) to an IRA is flexibility and the ability to consolidate 401(k) balances throughout your working life. Not only do you get more investment options, but you can also choose to convert money from a 401(k) rollover to a Roth IRA. Taxes would be owed at the time of conversion, but the money can be withdrawn tax-free in retirement. Unless you are in dire need of the funds and are okay with paying the early distribution penalty, you should roll a 401(k) to an IRA.
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To your success!
Noel B. Lorenzana
Disclaimer: Any accounting, business or tax advice contained in this article, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. If desired, I would be pleased to perform the requisite research and provide you with a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation services.
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