If you’ve recently retired, you may be getting advice from your financial adviser or broker to “roll over” your 401(k) or other qualified retirement plan into a an IRA. But for some people, keeping the money in the old employer’s plan might be better.
Both choices have their pros and cons.
Qualified retirement plans such as 401(k)s are safely out of reach of creditors (although they are still fair game for ex-spouses and the IRS). IRAs offer no federal protection from creditors, although some states may do so.
The only sure way to shield IRA assets from creditors is to declare bankruptcy. If that happens, the account is protected from creditors for up to $1,283,025 (scheduled to be adjusted for inflation this year). Rollovers from employer plans enjoy unlimited protection in a bankruptcy.
Bottom line: If you’ve been fielding irate calls or notices from creditors, or worry about the impact of a creditor judgment from medical bills or a lawsuit on your retirement account, you could be better off leaving the money with your former employer. The decision to leave the money with an employer is revocable, so you can transfer it somewhere else months or even years down the road if you change your mind.
If you think you may need to tap into the account before age 59 1/2 — not an unlikely scenario if you have been laid off and have little or no income left to meet living expenses — keeping money in an employer plan may provide better access for some individuals than an IRA. For example, if you are at least age 55 in the year you separate from service, you may take distributions from a company plan without penalty. By contrast, distributions you take from an IRA before age 59 1/2 may be subject to an early withdrawal penalty.
IRAs are typically more flexible when it comes to withdrawals. Those aged 59 1/2 or older can take money out of an IRA without restriction, and without penalty. Employers aren’t always so accommodating. Some may only allow withdrawals annually or quarterly, while others don’t permit them at all. Depending on the plan partial distributions, installment payments, or loans may also be allowed. Loans are not permitted in an IRA.
Some employers provide a wide range of investment options, while others have a more limited menu. In many cases a rollover IRA can provide investors with a much broader choice of mutual funds and securities. Just keep in mind that if you hold employer stock that has appreciated and decide to roll it over to an IRA, there could be tax consequences for any gains.
Once you leave a company you can no longer contribute to its 401(k), while a rollover IRA allows you to continue making contributions. This may be advantageous, for example, if you plan to continue working part-time in retirement.
If you decide to do a rollover IRA be sure to examine what a brokerage firm or bank offers. In the scramble to attract the growing baby boomer market for 401(k) rollovers banks, insurance companies and brokerage firms lay out the welcome mat, often quite aggressively. Some push their firm’s own mutual funds, which may not be the best performers or carry high fees. Others try to sell high-cost insurance products that don’t make sense for a lot of people. If you suspect this is happening, look elsewhere.
Also be careful about the details of the transfer. When you move money from an employer plan to an IRA you can either direct the employer’s financial institution to send the money straight to the new bank or brokerage firm, or have the check made out to you for deposit later. With the latter option the employer is required to withhold taxes, and you’ll only have 60 days to put the original balance (including the withholding amount) into an IRA to avoid taxes and penalties. Doing a direct transfer avoids that risk.
While it may be tempting to “cash out” of the plan by withdrawing the entire account balance, particularly for people with large credit card bills or other debt, it’s best to avoid doing this. The distribution will be subject to a federal tax withholding of 20 percent, as well as state taxes. A 10 percent early withdrawal penalty may also apply, depending on your age when you stopped working. Between taxes and penalties a $50,000 withdrawal could be whittled down to around $30,000.
And, of course, there will be less money in the account for retirement expenses. Unless there’s a pressing need, it’s much better to keep your money working for you by growing in a tax-deferred account.
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