5 Reasons to Let a Sleeping 401(k) Lie

"I've got this old 401(k) just sitting there; I need to figure out what to do with it."

My response to friends and family members in that predicament is usually pretty unequivocal: Roll it over.

To be sure, letting money sit tight in an old 401(k) plan is the path of least resistance, which is why many participants let their assets sit in the plans of former employers. According to data from Charles Schwab, 30% of 401(k) participants who left their jobs in the fourth quarter of 2008 had not done anything with their old 401(k) assets by the end of 2009.

Leaving the money behind in an old plan is, of course, better than cashing it out and spending it: If you're younger than 55, you'll pay ordinary income taxes and a penalty on the premature distributions, meaning that a 401(k) balance can shrivel by close to half when all is said and done.

And if your 401(k) plan is a particularly good one, there's no problem leaving the money behind: With your buying power pooled with other plan participants, you may have access to institutional share classes of funds, which typically feature very low costs and may be unavailable to investors with smaller balances.

But there are a couple of key reasons I often recommend getting the money out of your old 401(k) (or 403(b) or 457) plan once you've departed your employer. The first is that 401(k) plans sometimes charge a layer of fees for administration, or use high-cost share classes of mutual funds that have extra fees embedded inside of them. Those extra fees tend to be more prevalent in plans of smaller employers, simply because small 401(k) plans don't wield the same amount of investor dollars--and in turn bargaining power to drive down fees--as plans offered by the likes of  Microsoft (MSFT) and  General Electric (GE).

You can readily circumvent those extra costs by rolling the money into an IRA at a fund company or brokerage firm and populating it with low-cost funds or exchange-traded funds. The fact that IRAs offer open architecture is another point in their favor. Whereas 401(k) participants have to choose from a preset menu of investments, which may or may not be very good, IRA investors can buy almost anything, with the exception of some of the investments outlined in this article.

The last point in favor of rolling the money into an IRA is the ability to streamline and keep tabs on your assets; having fewer accounts to monitor can help you keep track of the big picture more easily than having lots of onesies to oversee.

That said, there are a few occasions when staying put in a former employer's plan is in fact the best course of action. Here are some of the key ones.

1. You can't buy comparable investment options on your own.
One of the key reasons to stay put in a former employer's plan is if it offers investment options that are unavailable to you as a smaller investor. Access to the aforementioned institutional share classes are one such option: For example, investors in  Vanguard Institutional Index (VINIX)--an S&P 500 tracker--pay just 0.04% in annual operating expenses, provided plan participants have $5 million in total invested in the fund. Those expenses go even lower--to 0.02% per year--for participants in plans with $200 million or more to invest in the Institutional Plus (VIIIX) share class of that fund. Price wars in index-fund and ETF land have driven costs down for retail investors, too, but not quite that low. In that instance--and provided you're not paying any administrative costs that override the benefits of your very cheap investment options--sticking with an old 401(k) plan can make sense.

An even bigger investment reason to leave money behind in an old 401(k) plan is if you'd like to invest in a stable-value fund, the likes of which you won't find outside the confines of the company retirement plan realm. Stable value funds' yields have dropped along with everything else over the past several years, but they're still invariably higher than cash yields. If you need a good share of your portfolio to remain steady--for example, if you're nearing retirement--stable value funds can be a terrific alternative to bonds, which carry interest-rate and/or credit-quality risk. (Interest-rate risk is arguably the bigger worry at this juncture.)

The same attractions--and then some--hold true for the G fund that's available to federal workers via the Thrift Savings Plan, the government's version of a 401(k) plan. Like stable-value funds, the G fund offers a better yield than cash--amounting to a 1.47% return over the 12 months through December 2012. (Because G invests in short-term Treasury bonds, it, like all government bond investments, has seen its yield drop substantially over the past several years.) Whereas the stability of stable value funds' NAVs are guaranteed by insurance contracts, the G fund's stable NAV is guaranteed by the U.S. government, making it a unique option in the investment landscape.

Investors will, however, have to weigh the attractions of such options against their overall investment program. For example, in this portfolio makeover, where the 401(k) assets were a relatively small piece of the total asset pie, using the stable-value fund to help build out this couple's total fixed-income exposure was a no-brainer. But for a younger person without a great need for stability, staying put in a 401(k) plan simply to take advantage of the stable-value option doesn't add up.

2. You may need early access to your money.
Investors in 401(k) plans who have left their employers have another lever that IRA investors do not: the ability to tap their assets a touch earlier--at age 55. (To be eligible, workers must reach age 55 or older sometime during the year they retire.) By contrast, IRA investors and 401(k) investors who retire before age 55 must wait until age 59 1/2 to be able to access funds in their accounts if they want to avoid the 10% early withdrawal penalty. Thus, if you're closing in on that age and would like to have access to your cash, staying put in your previous employer's 401(k) will make more sense than rolling the money over and tying it up an additional 4 1/2 years. Just be sure you've fully assessed your portfolio's long-run sustainability before contemplating withdrawals at such an early age. Also note that some 401(k) plans may not allow the age 55 withdrawal option.

3. You could need the extra legal protections.
Legal protections are another reason to consider staying put in an old 401(k). Although laws regarding creditor protections for retirement assets vary by state, company retirement plan assets generally have better protections from creditors and lawsuits than do IRA assets. Obviously, these protections will be a bigger consideration for those who have had credit or bankruptcy problems or work in a profession where there's a possibility they'll be sued.

4. You own company stock in your 401(k).
Another consideration comes into play if you have company stock in your 401(k). In that case, staying put is often a better bet than rolling the money over. The reason is that if you have company stock in a company retirement plan, you'll pay capital-gains tax on any appreciation over and above your cost basis when you sell the shares. (That differential is called net unrealized appreciation, or NUA.) If you roll over the company stock into an IRA, on the other hand, you'll pay ordinary income tax on the distributions. The Bogleheads Wiki has a thorough discussion of net unrealized appreciation. If this situation applies to you, check with a tax or financial advisor to help determine the best course of action.

5. You need the guardrails.
Finally, a little self-reflection is in order before deciding to take money outside the confines of a 401(k) and roll it into an IRA. Do you know how you're going to invest those assets? Keeping the money in a 401(k) plan provides at least a few safeguards: After all, these plans are overseen by fiduciaries who are legally required to look out for participants' interests, so the funds in the lineup tend to be well-diversified and vanilla--not the type of investments that usually blow up portfolios.

That's not to suggest you can't emulate the simplicity and sensible approach of a 401(k) on your own, however. You could simply buy a good-quality target-date fund in an IRA, or construct a simple portfolio along the lines of the one that Morningstar ETF analyst Abby Woodham laid out in this article.

 

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