EDITOR'S NOTE: This article was originally published in the June 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.
When Warren Smith's employer laid him off earlier this year, he had to make a decision that all new retirees face. He needed to decide whether to roll his 401(k) into an IRA.
Smith, 62, had been contributing 22% of his salary to his employer plan. The company, which coordinates corporate events, now uses him as a contractor, but he is not allowed to contribute to the 401(k). "I didn't feel comfortable keeping my money there," says Smith.
Also, Smith needed to make sure that his savings would last for decades, and he didn't think that the six mutual funds that the 401(k) offered would do the trick. Smith, who lives in El Cajon, Cal., says, "I didn't have the diversification that I have in an IRA." He decided to roll his 401(k) money into an IRA and hired an investment adviser to help manage his nest egg.
As baby-boomers join the retiree ranks, they are facing the same roll-or-not-to-roll decision. And many middle-aged workers, forced to find new jobs after being laid off from their old ones, must decide whether to leave their retirement stash with the old employer or move it to an IRA.
For the financial-services industry, millions of these decisions will add up to billions of investment dollars. More than 50 million employees and retirees hold $3 trillion in 401(k) plans, according to the Investment Company Institute.
Brokerage firms and mutual fund companies are in frenzied competition to capture your business. "That old 401(k) isn't going to take care of itself -- do something about it," demands the Charles Schwab Web site. TD Ameritrade and E*Trade are offering up to $500 to buy your rollover business.
And, employers are becoming increasingly possessive about 401(k) balances. Until recently, most employers didn't want the administrative hassle of maintaining former workers' accounts. Now one-third of all retirement plans, and two-thirds of plans with $1 billion or more, want to keep retirees in the plan after retirement, according to a study by Casey Quirk, a consulting firm.
Casey Quirk partner David Bauer says retirees often have the largest account balances. "If retirees roll assets out, it reduces a plan sponsor's ability to negotiate with plan providers for lower fees," he says. More employers are trying to keep 401(k) participants by offering low-cost index and exchange-traded funds, target-date retirement funds and annuities.
Should You Stay Or Should You Go?
Despite moves by employers to sweeten the deal, it makes sense in most cases for retirees and job switchers to roll their 401(k) money into a traditional IRA or a Roth IRA. Typically, company plans offer limited investment choices. "If you roll your money into an IRA, you have access to more investment options," says David Zuckerman, a certified financial planner in Los Angeles.
You also have the flexibility with an IRA to withdraw money whenever you need it. Not so with the typical 401(k). "Plans may restrict how you take the money out," says Rick Meigs, president of 401khelpcenter.com.
Withdrawal rules for 401(k)s vary, so check with your human-resources department before you decide what to do. Some limit the frequency of withdrawals. Others set all-or-nothing restrictions: A retiree who wants to take a distribution must withdraw all account assets. That would make it impossible to use your 401(k) to create a regular income stream during your retirement.
If you're looking for simplicity, consolidate all of your 401(k) accounts into a single IRA. With all of your retirement savings in one place, it's easier to monitor your investments, set appropriate asset allocations and rebalance.
It's also easier to handle your required minimum distribution after you turn 70 1/2, says Stuart Ritter, a certified financial planner with T. Rowe Price. With traditional IRAs, your RMD is based on the total amount in all your IRAs, and you can take the money from any account or any combination of accounts. If you have a 401(k) at age 70 1/2, you must calculate that RMD separately and take the money from that account. (There are no RMDs for Roth IRAs.)
An IRA also has estate-planning benefits: maximizing the chances that your heirs can take tax-deferred distributions over their lifetimes. Most 401(k) plans force heirs to take assets after the account holder dies.
Of course, beneficiaries can roll the inherited 401(k) into an IRA. But a rollover can be tricky, so you're best off handling the transfer yourself rather than leaving your heirs to deal with a plan administrator. "If they inherit a 401(k), they'll have to get the employer to do a direct transfer to an IRA," says Ed Slott, author of Your Complete Retirement Planning Road Map (Ballantine, $16). "You have to rely on the plan to do it right."
There are times when it makes sense to stick with the 401(k) -- at least for a while. If you retire or get laid off between ages 55 and 59 1/2, you can take penalty-free withdrawals from a 401(k). "You'll pay income taxes, but you won't have to pay the 10% penalty," says Slott. If you roll your money into an IRA, you must wait until age 59 1/2 to withdraw without a penalty.
It doesn't have to be an either-or proposition. If your plan allows, you can leave enough money in the 401(k) to cover expenses or possible emergencies until 59 1/2, while moving the rest to an IRA.
You might want to leave some money in a 401(k) if it is invested in fixed-income options with decent yields. If part of your 401(k) is invested in a guaranteed income contract, for example, consider keeping it where it is and transfer the balance to an IRA, says James Lange, author of Retire Secure! Pay Taxes Later (Wiley, $25). These investment instruments are contracts with insurance companies that offer a fixed rate of return over a set period of time. You cannot transfer a contract to an IRA.