Should you rollover your 401(k) to an IRA?

Brandon R. Amaral, CFP®, EA
Brandon R. Amaral, CFP®, EA

Founder & Financial Planner, Amaral Financial Planning

If you’ve ever changed jobs or been laid off, you probably heard about rolling your previous employer’s 401(k) to an IRA (Individual Retirement Account). While this strategy definitely has its advantages, there are also some disadvantages that should be considered as well.

From investment options to tax savings to avoiding fees, this article will look at the top three reasons you should and should not rollover your 401(k) to an IRA. While everyone’s situation is unique, it is best to have an understanding of all options so you can make an informed decision.

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Here are the top reasons you should and should not rollover your 401(k) to an IRA:

Reasons to rollover

A popular strategy among savvy investors is to rollover their old 401(k) accounts to an IRA, which they either self-manage or work with a financial advisor. Let’s look at some reasons you should do this:

Avoid administrative fees

Administrative fees cover the costs of maintaining the 401(k) plan. They pay for things like account statements and access to customer service reps. Administrative fees are in the form of a flat fee or a percentage of the total balance.

Employers sometimes pay these fees, but they are usually paid for by participants, especially if you no longer work at the company. These fees may or may not be disclosed.

Access to more investment options

401(k) plans are notorious for having very limited investment options. The menu of funds you can choose from usually ranges from 20-30 different types of mutual funds. The exact funds and fees associated depend on the plan sponsor (your employer) and plan administrator (the investment company that holds your account).

IRAs, on the other hand, are self-directed and are able to be invested in most stocks and index funds. This gives you the freedom and flexibility to invest in the companies that you want.

Take advantage of Roth conversions 

When it comes to investing, minimizing taxes tends to be a large consideration. With Roth IRAs, you can actually eliminate taxes on the growth of your investments, forever. When you convert pre-tax money to a Roth IRA, you will need to report the conversion as ordinary income and will owe taxes in that year.

Here’s how it works:

  1. Roll your old 401(k) over to an IRA
  2. Convert the IRA to a Roth IRA
  3. Pay ordinary income taxes for the amount converted
  4. Never pay taxes again on the Roth IRA money

You should consult a financial or tax advisor about the tax implications before initiating a Roth conversion.

Reasons NOT to rollover

While it might seem like a no-brainer to rollover your 401(k) to an IRA when you leave a company, there are actually some important reasons to leave it as-is or to roll it over to your new 401(k).

Take advantage of backdoor Roth conversions

For 2021, if your income is over $140,000 (for single taxpayers) or $208,000 (for married couples), then you can’t contribute directly to a Roth IRA. However, you are able to make non-deductible contributions to a Traditional IRA no matter your income level. If you rollover your 401(k), which has pre-tax money, to an IRA, this can create some tax issues due to the pro-rata rule.

According to the IRS, the pro-rata rule states that taxation of IRA accounts when converted partially or fully to Roth accounts will be calculated proportionally to the fraction of after-tax vs. before-tax contributions. The IRS will also aggregate all of your IRA values to determine this proportion.

As an example, let’s assume that you had $94,000 in a pre-tax 401(k) and rolled it over to an IRA. You also make a $6,000 non-deductible IRA contribution. Usually, you can convert the full $6,000 and wouldn’t recognize any tax, however, with the pro-rata rule, $5,640 would be taxable. This can amount to about $1,500 in additional taxes.

Taxable amount = (Pre-tax IRA money / All IRA money) X Conversion amount

$5,640 = ($94,000 / $100,000) X $6,000

A great strategy to avoid the pro-rata rule is to shelter your pre-tax money in a 401(k) plan. Whether you leave the pre-tax money in your old 401(k) or roll it over to your new 401(k), it will not be counted as “pre-tax money” for the purposes of the pro-rata rule.

Avoid advisor management fees

One of the main ways financial advisors get paid is through investment management fees on your investments. For many people, their retirement accounts represent the bulk of their life savings and net worth. It’s no wonder that advisors are biased towards recommending you rollover your 401(k) to an IRA in which they manage for you.

With management fees ranging from 1% – 1.5%, you can be missing out on significant returns over time. Let’s assume you have $100,000 in your 401(k) and you earn an average of 8% over 30 years. By paying 1.5% in management fees, you would have $350,000 less than if you didn’t pay management fees.

Take a 401(k) loan

Depending on your 401(k) plan, you may be eligible to take out a loan. While this is not typically recommended, in certain situations it may make sense to utilize this feature.

Typically, you can access up to 50,000 or 50% of your account (whichever is less) on a tax-free basis. You must repay the loan based on the rules of your 401(k) plan. The catch is that you must immediately repay the loan back if you leave the company, and are unable to take out a loan if you no longer work for that company.

The workaround here is to rollover your old 401(k) into your new 401(k). Now, you will be able to access the money and take out a loan.

Understanding all of your options is important before deciding whether or not to rollover your old 401(k) to an IRA. If you would like to work with a financial planner to walk you through your options, I would love to help you!

To learn more about becoming a client, schedule a complimentary meeting now!

Disclaimer: This blog is for informational purposes only, and should not be considered advice or recommendations. All opinions expressed herein are solely those of Amaral Financial Planning, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. You should consult your financial advisor, tax professional or legal counsel prior to implementation.