Olivia S. Mitchell is the International Foundation of Employee Benefit Plans Professor of Insurance/Risk Management and Business Economics/Policy at the Wharton School of the University of Pennsylvania. Catherine Reilly is Principal of CM Reilly Associates, a strategy consulting firm. John A. Turner is Director of the Pension Policy Center. All opinions are their own.
A key question confronting many older Americans is whether they should roll over their 401(k) plan assets into an Individual Retirement Account (IRA), versus continuing to keep their savings in their 401(k) plan. In what follows, we summarize our recent study discussing the complexity of this decision and the best options for two types of participants: financially sophisticated participants, and participants with low levels of financial literacy.
Here are some key factors to consider:
When might rolling your 401(k) plan assets into an IRA make sense?
- IRAs can offer retirees more investment options than do many 401(k) plans, including access to exchange-traded funds, individual stocks and bonds, and mutual funds.
- Retirees holding 401(k) accounts at several employers can simplify their financial lives by rolling over the money into a single IRA.
- IRAs can offer more flexible payout options, especially if the employer limits how much (and how often) retirees can withdraw from their 401(k) accounts.
- IRA providers can make annuities available, providing retirees with a steady income stream in later life. By contrast, 401(k) plans have only recently started adding annuities to their plan menus.
- IRAs provide the option of the charitable IRA rollovers or qualified charitable distributions. These permit donors age 70½ and older to exclude from their taxable incomes, and to count toward their Required Minimum Distributions (RMDs), certain transfers of IRA assets made directly to public charities.
- Terminated vested participants in 401(k) plans may be charged higher fees than current employees.
- Most large 401(k) plans have low fees, but some smaller ones do charge higher investment fees than those available to IRA investors.
- Terminated vested participants may want to roll over their 401(k) money into a Roth IRA if they anticipate that income tax rates will rise in the future.
- A participant who wants to pursue a Roth conversion strategy over several years is likely to find it easier to first roll the 401(k) assets into a pretax IRA, and then convert them into a Roth IRA over time.
When could sticking with your 401(k) be a better idea?
- Large employer 401(k) plans typically have very low costs and well-designed menus. For participants who lack the financial sophistication to navigate the IRA market, these may be a good, cost-effective solution.
- Since employers offering 401(k) plans legally must act in the best interests of plan participants, keeping retirement assets in a 401(k) plan provides fiduciary protection not found in IRAs. This includes employer oversight of plan investment options and costs.
- People still working at age 73 or older must take Required Minimum Distributions (RMDs) from their IRAs, but need not take RMDs from their current employers’ 401(k) plans. However, a 401(k) participant who is a 5% owner of the business sponsoring the plan must begin taking RMDs after reaching age 73 even if not yet retired.
- 401(k) plans offer better protection against bankruptcy or other lawsuits, while federal law limits the amount of money held in IRAs protected in bankruptcy.
- Retirees can usually access their 401(k) savings as early as age 55 without paying a tax penalty, while for IRAs, the earliest access age without a tax penalty is 59½. There is an exception, however. Under IRS rule 72(t), earlier withdrawals can be drawn without penalty if the participant takes at least five substantially equal periodic payments. The payments depend on the owner’s life expectancy (calculated using IRS-approved methods).
- Rolling over a 401(k) plan into an after-tax IRA can create complex problems relating to the taxation of distributions, particularly if the retiree holds esoteric assets such as real estate, artwork, wine, jewelry, and such.
What should financially literate 401(k) participants do?
Traditional economics focuses on financially literate decision makers who are presumably able to find low-cost investments for IRAs and be capable of navigating the wide range of investment options available to them without needing to hire a financial advisor. These individuals may feel that rolling over their nest egg is preferable. Nevertheless, for most participants, most large 401(k) plans have adequate investment options and charge low fees.
What should less financially sophisticated 401(k) participants do?
Those of us who are less financially sophisticated may find it difficult to identify low-cost investment options for IRAs, and more generally, to navigate the wider range of investment options available to them. Moreover, financial advisors, brokers, and other stakeholders actively market IRAs to older people, and until recently, few employer plans encouraged retirees to leave their money in their company plans. This market dynamic often resulted in financially unsophisticated participants making choices influenced by their financial advisors’ incentives, but that may not have been in their own best interests.
Moreover, professional advice costs in IRAs can also be steep: independent financial advisors usually charge about 1% of assets per year and often require a minimum balance of $100,000. Automated computer-driven robo-advisors are less expensive, charging around 0.25% of assets per year; these also require low or no minimum balances.
It is worth noting that this perspective is subject to debate. A recent GAO study suggested that some financial advisors take advantage of less financially sophisticated participants, telling them that they would have the same fiduciary protection if they rolled over their 401(k) assets to an IRA. Nevertheless, the ICI has taken issue with several of those conclusions.
In any event, less financially sophisticated retirees are likely to do better by remaining in their low-fee large employer 401(k) plans if they can. Removing the barriers to this by making it easier to consolidate multiple retirement savings plan into a single 401(k) and offering more flexible withdrawal options would make it easier for such participants to use their employer plans to pay themselves retirement income.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
