The Frugal Fiduciary Small Business 401(k) Blog by Employee Fiduciary

401(k) Rollovers - How to Evaluate Your Options

Written by Eric Droblyen | Jun 23, 2021 10:30:00 AM

Switching jobs and unsure what to do with your 401(k) account? If you’d like to keep growing your retirement savings on a tax-deferred basis, you can leave your account in your former employer’s plan or roll it into your new employer’s 401(k) plan or an Individual Retirement Account (IRA). Rolling your account can seem like the obvious choice, but in some cases, leaving it could grow your retirement savings faster.

To make the best 401(k) rollover choice, you must be able to evaluate your 401(k) and IRA options. The stakes are high. The wrong choice could force you to work years longer than necessary to afford retirement. Here is what you need to know to make an informed decision:

The Pitfalls that Make Retirement Less Affordable

To retire as soon as possible, you must avoid three pitfalls when saving throughout your working years - underperforming investments, inappropriate asset allocation, and excessive administration fees. Avoiding these pitfalls could add hundreds of thousands of dollars in compound interest to your savings by the time you retire.

  1. Underperforming investments - 401(k) and IRA investments come in two basic types – active funds and index funds. The main difference is their investment objective. Active funds try to outperform their market benchmark (e.g., S&P 500), while index funds try to match it.  I define underperforming investments as active funds that underperform “comparable” index funds (i.e., funds with a similar benchmark) over time, net of fees.  Studies show most active funds fit that bill.  
  2. Inappropriate asset allocation – Asset allocation is an investment strategy that aims to balance risk and reward by allocating an investment portfolio among different asset categories - such as stocks, bonds, and cash. Maintaining a proper balance is important. Otherwise, you could miss out on gains by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when near retirement. 
  3. Excessive administration fees – 401(k) and IRA providers charge these fees to administer your account annually. They can be “direct” and “indirect” in nature. Direct fees are deducted from your account balance, while indirect fees (often called “hidden” fees) increase the cost of your investments – lowering their returns. The two most common forms of indirect fees are revenue sharing and annuity “wraps.” 

The 401(k) and IRA Features You Want for the Long-Term

To avoid the pitfalls that make retirement less affordable, you want a 401(k) account or IRA with three features:

  1. Market returns – Studies show index funds outperform most comparable active funds over time, net of fees. All of the leading providers – including Vanguard, Blackrock, and Schwab – offer excellent choices. Returns match benchmarks and fees are low across the board. Your retirement savings should earn no less over time.  
  2. Professional investment advice - To maintain an appropriate asset allocation, I strongly recommend professional investment advice. An Aon Hewitt study found professional investment advice increased the median retirement account returns by 3.32% annually. 
  3. Minimal administration fees – Administration fees reduce your investment returns dollar-for-dollar. The lower, the better.

The Key Differences Between 401(k) and IRA Accounts

401(k)s and IRAs have different features you want to consider when deciding whether or not to rollover a 401(k) account with a former employer. 

Feature

Workplace 401(k) plan

Individual IRA

Investment options

Your options are limited to the investment menu selected by your employer. That is not necessarily a bad thing. Employers have a fiduciary responsibility to select a “prudent” investment menu for you. A prudent investment is simply a fund that meets its investment objective for reasonable fees. 

However, this responsibility does not guarantee a prudent investment menu. In fact, “imprudent” investment selection is one of the top causes of 401(k) lawsuits today. 

In general, your options are nearly limitless. As a practical matter, however, most IRA providers will restrict your options to publicly traded or proprietary investments. 

Most IRA providers have no obligation to limit your investments to prudent options.

Professional Investment advice

Your options are limited to the forms offered by your plan. Most plans offer at least one of the three basic forms - Target-Date Funds (TDFs), a financial advisor, or “robo” (algorithm-based) advice. 

You choose the form you want. To pick the best form, you should understand their pros and cons.

Administration Fees

There is no such thing as a free 401(k) plan. All providers charge fees for delivering plan administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and professional investment advice

If these fees are paid by your plan, an IRA will probably cost less than your 401(k) account. 

If admin fees are paid by your employer, your 401(k) account will probably cost less than an IRA.

401(k) accounts are more prone to “hidden” admin fees like revenue sharing and annuity “wraps” than IRAs but these fees are getting less common as employers root them out.

IRA admin fees are usually low. Especially when the IRA provider limits their investment options to proprietary funds.  

Participant loans

401(k) plans may or may not allow participants to borrow against their account balance. When a plan allows loans, they usually restrict access to active employees.

IRAs do not permit loans.

Premature Distribution Penalty

Generally, 401(k) participants must wait until age 59 ½ to withdraw their account without a 10% premature distribution penalty. However, a participant who retires, quits or is fired after age 55 can withdraw without penalty. 

IRA account holders must wait until age 59 ½ to withdraw their account without penalty.

Required Minimum Distributions (RMDs)

In general, RMDs from a 401(k) account must start at age 72. Non-business owners can postpone RMDs until their retirement, if later.

RMDs from traditional IRAs must start at age 72.

RMDs from Roth IRAs are not required until the death of the owner.

Creditor protection

Federal law protects 401(k) accounts from most creditors.

IRA creditor protection depends on state laws.

Net Unrealized Appreciation (NUA)

When a 401(k) account is cashed out, the proceeds are generally taxed at the participant’s income tax rate.  NUA – or gains on employer stock - can be taxed as long-term capital gains.  

Not available to IRA accountholders.

Now You’re Ready to Make a 401(k) Rollover Decision!

401(k)s and IRAs can offer dramatically different investments, fees, and features. Their variability is why making the right 401(k) rollover decision is so important. Choosing an overpriced 401(k) or IRA now could set your retirement back years. 

Need further assistance evaluating your 401(k) rollover options?  Talk to a fiduciary-grade investment adviser.  While brokers and insurance agents can give conflicted rollover advice that puts their interests ahead of yours, an investment adviser is obligated by law to give impartial advice that’s in your sole best interest.