The 401(k) is a blessing for many people, as it allows them to build wealth over time using dollar-cost averaging.
Still, sometimes it makes more sense to channel some of that money from the employer-based account into your own individual retirement account. The ever-astute Rick Kahler, the founder of Kahler Financial Group, in Rapid City, S.D., tells us why:
Larry Light: Why and when should you move your 401(k) into an IRA?
Rick Kahler: If your employer offers a 401(k) or other retirement plan, contributing to that plan is a foundation of your retirement savings. However, as you approach retirement age, you might consider moving some of your retirement funds out of your employer’s plan and into an IRA at a custodian like TD Ameritrade or Fidelity.
Such a rollover is often done when you leave an employer, though many employers give you the option of keeping your retirement account with them. What isn’t popularly understood is that you also can do a rollover while you’re still employed, as long as you are over 59½.
Light: Why do this?
Kahler: One reason to consider leaving your employer’s plan is that most of them have higher overall fees than an IRA, especially if you choose from low-cost index mutual funds or exchange traded funds from a company like Vanguard or Dimensional Fund Advisors. It’s not uncommon to save up to 1% annually by making a rollover into these mutual funds.
However, the costs of an IRA are not always cheaper. If you have a Thrift Savings Plan through the federal government, the total costs are .03% a year. This is far cheaper than the average equity fund that charges 1.3% in fees, or even Vanguard and DFA, which charge just .09% on some funds.
The disadvantage with a TSP, like most employer plans, is their very limited investment options. The TSP offers about six options. Most 401(k)s will offer several times that—still a pittance compared with the 13,000 available at most discount brokers.
Light: What about withdrawing the money to live on? Is there a difference?
Kahler: Another reason for a rollover is what happens when you retire and need to withdraw funds from your account. You can withdraw money from an IRA at any time without penalty after age 59½, but withdrawing money from a past employer’s 401(k) plan will require jumping through a few more hoops.
Another advantage of IRAs is that you can consolidate a number of employer accounts into one IRA. You can also withdraw funds from an IRA at any age without penalty for college expenses, which you cannot do from an employer plan.
Light: How do RMDs factor in?
Kahler: One issue that surprises most people is that the required minimum distributions rules are reversed for employer plans. An RMD is never required with a Roth IRA. However, an RMD must be taken from a Roth 401(k) when you turn 70½.
For this reason I recommend you roll over a Roth 401(k) before you turn 70½. The flip side of this is that when you turn 70½ you do have to take RMDs from a traditional IRA, if you are still working at the company and contributing to the plan. Only a committee could have made up these rules.
Light: What about charitable giving?
Kahler: The new tax code has made charitable giving less tax advantageous. However, if you are over 70½, you can give to charity tax-free from your IRA via a qualified charitable distribution. Employer plans don’t allow QCDs.
Light: What about transferring the money into a Roth?
Kahler: Another big advantage to an IRA is the ability to do Roth conversions, which cannot be done with an employer’s plan. It’s especially important to do such conversions before turning 70½ when your RMDs and Social Security benefits (assuming you wait until 70) kick in and raise your taxable income and possibly your tax bracket.
Taking advantage of lower tax brackets prior to age 70 to convert part of traditional IRAs to Roths can lower your RMDs, which lower your tax liability, and let some of your retirement funds grow tax free forever.
Done properly, a rollover from an employer’s plan to an IRA is free of any tax consequences. However, it’s important to evaluate the advantages and disadvantages carefully before you act.
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