The nine-year stretch of rising stock prices won’t last forever. So now’s a good time for investors to bear-proof their 401(k)s before the next financial storm.
Individual retirement accounts have been attracting record amounts of assets, even though relatively few people actually contribute money to them.
An oxymoron? Not really. The growth of IRAs results from their widespread use as tax-sheltered repositories for money that has been building up in 401(k)-style plans.
When leaving a job, workers and retirees must decide what to do with their 401(k) assets. Moving them to an IRA often is the best choice.
“Making these types of decisions sometimes comes at an unexpected time due to a layoff, career change, personal emergency or an unexpected retirement,” said Alan Norris, a certified financial plawithnner at Norris Wealth Management in Phoenix.
The decision is complicated by differing investment options, variances in expenses, tax traps and more.
“Knowing your options ahead of time can save you time, money and a lot of stress,” he said.
Only about one in eight households contributes money to an IRA, yet IRAs held $8.4 trillion as of a 2017 tally by the Investment Company Institute.
“Rollovers from employer-sponsored retirement plans have fueled the growth in IRAs,” said the institute, the national mutual-fund trade organization.
Here are some of the issues involved.
Where to put it
People with money in a 401(k) account or similar plan usually have three or four options when leaving their employer. If allowed, they might be able to keep the account intact with that company.
They also might be able to transfer it into a 401(k) plan at the company where they’re heading, assuming the person is taking a new job and that business or entity has a retirement program.
A third option is to cash out the money; a fourth is to shift the assets to a rollover IRA established at a bank, brokerage, mutual fund company or other financial institution — companies also known as IRA custodians or trustees.
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Taxes influence the decision
Cashing out usually is the worst choice, as the tax bite could be severe. Unless you kept your assets in a Roth 401(k), ordinary income taxes would apply on the amount withdrawn. (Taxes might apply if you’ve held the account fewer than five years.)
You also could face a 10 percent penalty if you’re under age 59½, and the distribution could be subject to 20 percent federal withholding. Plus, a permanent withdrawal would remove a big chunk of your retirement assets.
“Cashouts really work against a retirement savings discipline,” Norris said.
You can avoid these tax obstacles if you keep the money at your old employer or transfer it to the new one but, as noted, not all entities allow these options. Moving to an IRA is the fallback choice.
More on rollovers
There are a couple of ways to establish a rollover IRA.
You can do so by taking possession of the cash yourself, then reinvest it with a new financial custodian. Or you can have the money sent from your old employer to the custodian. Both are designed as tax-free moves, but there are some differences.
With the former, you take the distribution, then reinvest the money into a new IRA at the financial firm of your choice within 60 days, meaning that this can become a short-term loan if needed.
Failing to complete the process in time can trigger ordinary taxes and possibly that 10 percent penalty. Regardless, 20 percent withholding applies.
With a transfer, the money is sent directly from your old employer to the financial institution, without your touching it. Tax pitfalls are avoided.
“The method that causes the fewest headaches is a trustee-to-trustee transfer,” Norris said.
With a rollover, by contrast, “Waiting for a check to arrive by mail on an unknown date, attaching the correct transmittal paperwork, forwarding it to the correct address within 60 days and then tracking the delivery can create unnecessary anxiety,” he said.
Investment options and fees
One advantage of moving the money into an IRA is that you would have wider choices in terms of investments.
“In an IRA, you can choose low-cost index funds; you also can choose options like CDs or individual bonds,” said Dana Anspach, a certified financial planner at Sensible Money in Scottsdale.
“In an employer plan, you are limited to the choices they have pre-selected for you.”
Also, fund expenses and other investor-borne costs could be considerably lower in a rollover IRA compared with a 401(k) plan, especially smaller and less efficient plans.
Some small 401(k) programs might have reasonable costs in the range of 0.7 percent to 1.5 percent or so annually, but other plans charge much more, Norris cautioned.
In general, index mutual funds and exchange-traded funds, which are widely available for IRAs, are among the least costly choices. Fidelity Investments, for example, recently unveiled two new Zero mutual funds with no ongoing expenses at all.
Desire to simplify
Another factor affecting whether and where to move an account involves your own financial clutter and oversight abilities.
In a survey, the Investment Company Institute found that people selecting a rollover did so for several reasons. Preserving the tax-deferred status of their assets obviously was important, but so too were desires to consolidate assets and not leave assets with a former employer.
“When you have accounts in numerous places, it becomes more cumbersome to accomplish basic tasks like rebalancing your portfolio, updating your address or changing your beneficiaries,” Anspach said.
It’s even possible to lose track of a 401(k) account left with a former employer, especially if the dollar amount is fairly small, Norris said.
If you choose the IRA route, it’s wise to lean toward a large, well-established financial company that offers competitive fees and wide investment choices. Anspach cites Fidelity, Charles Schwab, Vanguard and TD Ameritrade as examples.
“Big firms like these have safeguards in place to help protect your accounts from fraud,” she said. “They also invest (heavily) in technology, so you’ll be able to easily manage your accounts online.”
Although Anspach usually recommends IRA rollovers over leaving the money with your old employer, one exception involves people with serious debt problems or facing lawsuits.
Both IRAs and 401(k)s offer considerable creditor protection should you file for bankruptcy, she said, but IRA protections for nonbankruptcy legal issues vary by state.
In many states, including Arizona, IRAs enjoy strong protection, but that protection might be limited elsewhere. If you are facing potential legal threats, “Check your state laws to see how much protection your funds would have if they are rolled to an IRA,” Anspach suggests.
Reach the reporter at firstname.lastname@example.org or 602-444-8616.
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