Roll Over Your 401(k) or Leave It Behind?

Question: I'm leaving my job, but my former employer said I could leave my 401(k) assets in my old plan. Would I want to do that?

Answer: It's a good bet that most people will switch jobs at least a few times over the course of their career.

As explored in this Wall Street Journal article--in contrast to decades past when departing or retiring employees were urged to take their retirement money out of the plan when they left in order to reduce administrative fees--nowadays many company retirement plans have shifted some of the administrative and investment-related expenses to employees. As such, some companies have increasingly persuaded retiring or departing employees to leave their retirement savings in their old plan as they move on, in order to retain a large pool of retirement assets that would enable the company to negotiate lower fees with the outside money managers that run their retirement-savings plans.

It should be noted, too, that for those investors who work with an advisor, the Department of Labor's fiduciary rule will likely have a major impact on recommendations surrounding rollovers. Morningstar's Scott Cooley thinks the clear intent of the DOL is to keep more assets in high-quality 401(k) plans. It will be more difficult for advisors to recommend IRA rollovers without a compelling reason, such as a plan that doesn't allow participants to leave their money behind when they move on, very high-fee plans, or situations in which the advisor can offer a product in an IRA—such as an annuity—that probably isn't available in the 401(k).

But what you ultimately decide to do with your 401(k) assets should depend on what's in your best interest. And in most cases--assuming your balance is over $5,000--it does make the most sense to roll your money over into an IRA or into your new 401(k) plan, if that's allowed. (Leaving the money behind or rolling it into your current employer's 401(k) may or may not be allowable--the specific bylaws vary by plan, so check on that first.)

That said, there are some good reasons to consider leaving your assets within the confines of a former employer's plan. (Though you will not be able to make additional contributions to your balance if left in a former employer's plan, your money will still enjoy tax-deferred compounding.) Here are some considerations to help you weigh the pros and cons of both decisions.

Roll It Over

Reason #1: You can do better on costs in your new plan, or on your own. Do some due diligence on your new plan and your old plan. (See this article on how to do a basic audit.)

Often, 401(k) plans charge administrative fees, and many times the participants themselves bear these costs. Other times, plans 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 have fewer investor dollars.

In contrast, larger plans can charge lower fees. With your assets pooled with other plan participants', your new employer's plan may have access to institutional share classes of funds, which typically feature very low costs and may be unavailable to investors with smaller balances. For example, let's look at some different share classes of

If your new plan has reasonable expenses, low-cost options, and a robust investment lineup, you might want to consider rolling your assets from your former employer's 401(k) into your new one, if that's allowed by the plan provider.

Alternatively, you could roll your 401(k) balance into a no-fee IRA at a discount broker or fund company. This may be your only option if your new employer's 401(k) plan will not accept a rollover from your old 401(k) plan. Or, if your old plan was just OK, and your new one doesn't look that much better, an IRA may be your best bet. (As discussed in this article, if your 401(k) is lousy, you may decide to invest just enough to earn matching contributions and then turn to an IRA with any additional contributions.)

It's easy to avoid paying excessive fees if you roll your money into an IRA at a fund company or brokerage firm. Unlike 401(k)s, you won't be saddled with administrative costs. And also unlike at 401(k)s, where you must choose from a preset menu of investment selections, IRAs offer so-called "open architecture," meaning you can buy almost anything--namely, low-cost funds, or exchange-traded funds.

Reason #2: Streamline and simplify your accounts. This point may seem obvious, but it shouldn't be understated, in my opinion: Having fewer accounts can help you streamline your monitoring and rebalancing efforts. And having your assets in one place can allow you to better assess your overall asset mix.

And though this may seem like an issue that's far in the offing for younger investors, consolidating your retirement accounts will ultimately facilitate the process of taking required distributions, which become required after age 70 ½. According to IRS rules, if you have more than one IRA, you must calculate the required minimum distribution for each IRA separately (using the IRS-supplied formula) each year to determine your total amount owed, even if you only plan to withdraw from one account to satisfy the whole distribution. If you have more than one defined contribution plan, you must calculate and satisfy your RMDs separately for each plan and withdraw that amount from that plan (with some exceptions). Consolidating your accounts won't reduce the size of your required minimum distribution or lessen your tax bite, but it could make your bookkeeping a lot easier.

Leave It Behind

Reason #1: The plan has good investment options and low fees. The flip side of the scenario discussed earlier may be true: Your former employer's plan has lower or no administrative fees, or it may be larger and thus have access to cheaper institutional share classes of funds than your new plan. Or your old plan may feature a better investment lineup.

Reason #2: You can't buy comparable investment options on your own. Another reason to leave money behind in an old 401(k) plan (or roll it over to a new one) is if you'd like to invest in a stable-value fund, which are only available within defined-contribution plans (not in IRAs). These funds comprise a portfolio of high-quality bonds but they also purchase insurance contracts that aim to provide price stability on a day-to-day basis. Thus, they aim to deliver income comparable to that of short- to intermediate-term bonds, with volatility over the long term similar to that of money market funds and other cash instruments.

Reason #3: 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 can afford you the flexibility to use a strategy that can have some tax advantages.

The tax code allows special treatment of company stock under "net unrealized appreciation" rules that can potentially save you a lot of money in taxes if you have highly appreciated securities and are in a high tax bracket. Essentially, as opposed to paying ordinary income tax on the market value of the shares at the time of sale, the rule allows you to 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, and you do have to pay ordinary income taxes on the cost basis of the shares.) If this situation applies to you, check with a tax or financial advisor to help determine the best course of action.

Reason #4: You may need earlier access to your money. IRA investors and most 401(k) investors 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. But there is an exception to this rule for employees who quit, retire, or were fired the year they turn 55 or after. If you find yourself in this specific circumstance, leaving the money in the 401(k) plan of the company you're departing could make more sense than rolling the money over into an IRA and tying it up for an additional 4 1/2 years. (Check with your plan first to make sure this would be allowed.)

Reason #5: You think creditors may come knocking. Hopefully you wouldn't find yourself in this situation, but in case you do: 401(k) plans offer a better level of protection from creditors than IRAs do. While 401(k)s and 403(b)s are fully protected from creditor judgments, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 protects IRAs from creditors up to $1,000,000 (adjusted for inflation).

Just Don't Cash It Out! Whatever you do, don't succumb to the temptation to take the lump sum in cash. You'll take a big haircut on the money via early withdrawal penalties, and you'll miss out on decades of compounded growth.

If you're rolling over the balance, avoid temptation and just plain hassle by having your former 401(k) provider make the check payable to the new IRA or 401(k) provider and send it directly to them, rather than to you. If the check is made out to you, 20% of the balance will be withheld for income tax. You'll then have 60 days to get that money deposited into an IRA or another 401(k); if that deadline comes and goes, the distribution will count as a withdrawal and you'll owe ordinary income tax and a 10% early withdrawal penalty if you're not 55 or older.

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