Rolling Your 401k Into an IRA can Boost Returns
Yes, you can take it with you. And you probably should.
If you are like many American workers, you change jobs every few years. And each time, you face the same critical decision. What should you do with your 401(k) plan?
My advice: If you are a savvy do-it-yourself investor, switch your nest egg into an individual retirement account. But if you are looking for safety or you have a shaky grip on your finances, leave your money in your old employer's plan or transfer it to your new company's 401(k). Here's why.
Gunning for growth.
If you are an investment junkie, you are probably salivating at the idea of getting your 401(k) money into an IRA.
No longer will you be limited by your 401(k) plan's investment choices. Instead, with an IRA, you will be free to buy pretty much any stock, bond or mutual fund you want, allowing you to slash investment costs and better diversify your portfolio.
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As an added bonus, getting the money into an IRA could save your heirs a truckload of taxes. If you die with money in your 401(k) plan and you name somebody other than your spouse as the beneficiary, your unfortunate heir could face an immediate and massive tax hit, because your employer will likely insist that your 401(k) be cashed out right away.
"That's the biggest drawback of leaving the money in the 401(k)," says Pittsburgh estate-planning attorney and accountant James Lange.
By contrast, with an IRA, you could name, say, your children as beneficiaries, and they could then draw down the account over their lifetime, thus reaping years of extra tax-deferred growth.
Opting for safety.
Because of the estate-planning benefits, Lange typically favors swapping 401(k) balances into an IRA.
Nonetheless, he recently advised two doctors to leave their money in their 401(k) plans, because 401(k) plans offer somewhat greater protection against creditors. That greater protection could be a huge plus if either doctor were sued for malpractice.
Conservative investors might also want to keep at least a portion of their 401(k) balance in either their old or new employer's plan. The reason: Many 401(k) plans include stable-value funds, which offer a combination of healthy yield and stable principal that's hard to find outside of a 401(k).
As I see it, a 401(k) is also the safe choice for those who haven't quite got their finances under control. Sure, you will get greater investment flexibility with an IRA. But for many folks, that flexibility will cause more harm than good, because they will trade too much or they will be overwhelmed by the bewildering array of investment choices. Building a sensible portfolio within a 401(k) is far less daunting, thanks to the limited investment options.
Moreover, if you use an investment adviser, you will probably be better off with your money in a 401(k). How come? If you have an unscrupulous adviser, he or she won't get the chance to mismanage your account. And if you have a top-notch adviser, you could get some great free advice.
Many brokers and financial planners charge fees and commissions on the accounts they directly oversee, such as money in IRAs and taxable accounts. But when it comes to clients' 401(k) plans, they will often help clients pick the right funds - at no additional cost.
If you transfer your 401(k) to your new employer's plan, you may also be able to borrow against the balance. I don't like 401(k) loans, which allow you to borrow half of your account balance, up to $50,000. There's a perception that these loans are some sort of financial freebie, because you pay interest to yourself.
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In truth, these loans can prove fairly costly, because you miss out on the investment gains that the borrowed money could have earned. Still, if you really need to borrow, you are better off tapping your 401(k) than running up your credit cards, which will likely cost far more.
"The real concern about plan loans is the inability to repay them," says David Wray, president of the Profit Sharing/401(k) Council of America, based in Chicago. "Typically, if you can't repay your loan within a month of terminating your employment, that's going to count as a distribution, and you'll owe both taxes and penalties."
Going for broke.
Which brings us to the one thing you shouldn't do. Many folks neither leave their money in their old employer's plan nor arrange a "trustee-to-trustee" transfer directly to an IRA or their new 401(k).
Instead, they ask their employer to cut them a check. "You don't ever want to get the check," says Nicholas Kaster, a tax lawyer with publisher CCH in Riverwoods, Ill.
Why not? The financially reckless will spend the money. But even if you plan to reinvest the money in an IRA, you may have made a huge blunder. Your employer will send you a check for 80 percent of your 401(k) balance, with the other 20 percent going to Uncle Sam.
You can reclaim that 20 percent with your next tax return. But in the meantime, you have to get 100 percent of your account balance into an IRA within 60 days. What if you can't scrounge up the other 20 percent? You will get slapped with income taxes on the money involved, and possibly tax penalties as well.
- Strategy: If you hold company stock in your 401(k) and retire or change jobs, gains will be taxed at the lower capital-gains rate if you take the shares as a lump-sum distribution.
- Downside: You immediately have to pay income taxes - and possibly a tax penalty - on the stock's "cost basis," the value at which you acquired the shares.
- Bottom line: This maneuver is worthwhile only if you have a big gain on the stock.
Source: online.wsj.com - 08-08-2004