Be Smart When You Rollover Your 401(k)

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There are few better investment returns than an employer’s matching contribution made to your 401(k). But after you retire or leave that company’s employment, you should almost always roll your 401(k) into an IRA for better investment choices. Being smart by rolling over your 401(k) can pay dividends for decades.

Most people leave the money in their old 401(k) plan or roll the money into their new employer’s plan. Neither of these options escapes the fees and limitations associated with 401(k) plans. Even worse, taking a lump-sum cash distribution and paying taxes and penalties can be detrimental to your long-term financial well-being. The best strategy is almost always to implement a direct “trustee-to-trustee transfer” to an IRA rollover account.

There are five main advantages that can be gained by completing an IRA rollover of your qualified plan assets.

Advantage #1: Full Range of Investment Vehicles

Employer-sponsored retirement plans tend to have a limited number of mutual fund investments for you to choose from, typically less than two dozen. Regardless of how good the choices are, an IRA provides the full range of investment options so that you can construct a portfolio better tailored to your financial goals. IRAs offer a nearly unlimited number of mutual funds, exchange-traded funds (ETFs), closed-end funds, and individual stocks and bonds to choose from.

Advantage #2: More Asset Classes for Better Diversification

Having the full range of asset classes is even more important than the full range of vehicles. We use the following six asset classes: Short Money, U.S. Bonds, Foreign Bonds, U.S. Stocks, Foreign Stocks, and Hard Asset Stocks. Further diversification can be achieved by adding subcategories such as small- and mid-cap stocks and by emphasizing a “value” approach over “growth” when investing in equities.

The average 401(k) plan is normally filled with several redundant U.S. large-cap stock funds. By contrast, they lack multiple foreign investment choices. In addition, their foreign stock fund is sometimes a “global” stock fund that can be heavily invested in U.S. stocks. Global funds dilute the benefit of diversifying into foreign markets.

Another asset class often missing from a 401(k)’s choices is hard asset stocks. Hard asset stocks include natural resources, energy, timber, precious metals, and real estate investment trusts. Hard asset stocks have performed well over the past five years. Investment in hard assets protects your portfolio against some of the risks associated with inflation. This is particularly important if you have any fixed income investments.

Advantage #3: Lower Expense Ratios

Odds are that the choices in your 401(k) have higher than average fees. A 401(k) plan lumps administrative fees with management fees and does not typically make the total fees that you pay readily available. Employers aren’t required to provide you with written information about the administrative costs for online account access, educational seminars and other third party administration.

On top of administrative fees, each fund charges an annual operating expense ratio. The average large-cap equity mutual fund has an expense ratio of 1.28%. In contrast, a large-cap exchange traded fund’s expense ratio is typically under 0.15%.

While employers have a fiduciary responsibility to run the plan for the benefit of the participants, most plans make their money through maximizing these hidden fees and minimizing the out-of-pocket employer expenses. As amazing as it sounds, some 401(k) plan’s generous matching contributions are completely eroded by the plan’s excessive expenses. Some employers would do better for their employees to forgo the match and reduce the hidden expenses by paying some of the costs out-of-pocket.

Advantage #4: Roth IRA Conversions

Another benefit of completing an IRA rollover is gaining the ability to convert your rollover IRA to a Roth IRA. A Roth IRA not only grows tax free, but, unlike a traditional IRA, provides you with tax-free withdrawals. Furthermore, Roth IRA’s are not subject to required minimum distributions when you reach age seventy and a half.

Most of the benefits of a Roth account can also be passed along to your designated beneficiaries. This preserves their ability to stretch tax-free withdrawals from an inherited Roth over their entire life.

Converting to a Roth IRA is a taxable event and is subject to income eligibility. It requires some long range planning, and for many clients, the best strategy is to convert a portion of their traditional IRA each year to stay within their current income tax bracket.

In 2008 you will be able to convert a 401(k) directly to a Roth IRA instead of using the current two-step process. In 2010, there will be no income restrictions on who can do a Roth conversion. This is a rare tax gift from Congress and is a huge retirement planning opportunity regardless of your age.

Advantage #5: More Control for Estate Planning

Finally, an IRA account permits flexibility in designating beneficiaries and, therefore, allows you to control how your assets are distributed by your estate plan. Your heirs can have the ability to “stretch” the IRA’s tax-deferred growth and required minimum distributions over their own life expectancies. This intergenerational planning can provide a tax advantage over several decades. In another significant change brought about by the Pension Protection Act of 2006, a non-spouse beneficiary (such as a child) who inherits an employer-sponsored retirement plan can now complete a direct rollover to an Inherited IRA and utilize this stretch.

When making an IRA rollover there are two important considerations. IRA rollovers have some fairly complex tax rules and procedures that must be followed to ensure that your rollover is a tax-free event. The distribution must be payable directly to your IRA’s custodian and not to you, personally. Also, you need to be certain that the IRA custodian you are rolling your 401(k) to has the best possible selection of investments.

Retiring from your job or changing employers provides an important financial planning opportunity. You may benefit from having a fee-only advisor help you evaluate which strategies are in your best interest. To find a fee-only professional in your area, visit

Photo by Jessica Henderson on Unsplash

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.