Should I roll my 401(k) into an IRA?
People ask me all the time: should I roll my 401(k) into an IRA? This question usually comes up when someone is changing jobs or retiring, but there are other triggers, too. For example, some plans allow workers to take something called an “in-service distribution,” meaning they can roll their 401(k) money into an IRA while they are still employed. Though I tend to favor IRAs for their flexibility, simplicity, and low cost, the best choice is not always obvious. Here are some key points you should consider.
Employer-sponsored retirement plans, including 401(k) and 403(b) plans, have some compelling benefits. One of their most important benefits is that they are protected by a federal law known as the Employee Retirement Income Security Act of 1974, or ERISA. ERISA protects the interests of participants and beneficiaries in private sector employee pension and welfare benefit plans. ERISA does the following:
- Requires plans to provide participants with information about the plan including plan features, investment performance and fees.
- Sets minimum standards regarding employee eligibility as well as minimum benefit vesting and accrual schedules.
- Defines who is a fiduciary for the plan and what is required of them.
- Gives participants recourse against plan sponsors or fiduciaries who do not live up to their fiduciary duty.
One of the strongest protections in ERISA is something known as the anti-alienation provision. This provision makes it nearly impossible for creditors to lay claim on assets held in 401(k) plans. In fact, unless there is fraud, chances are your 401(k) assets are safe against all legal perils except divorce and the IRS.
IRA’s, on the other hand, are not covered by ERISA, so IRA holders do not enjoy all the protections that ERISA affords. IRAs provide some protection against creditors, but the amount of protection varies by state.
In California, IRA assets are protected from creditors only to the extent necessary to provide for the support of the debtor’s spouse and dependents, after considering all other resources available. This law was modified in 2007 by California’s second district court of appeals. The Court ruled that if IRA assets came from a 401(k) rollover, the creditor protections of the 401(k) apply to the IRA. This ruling obviously bolstered the position of IRA holders, though an IRA holder may have to spend money on lawyers to claim that protection in court.
Another benefit of 401(k) plans over IRAs is the ability to borrow money from the plan. Although I do not usually recommend borrowing from 401(k) plans, a loan can be a real benefit in situations where you need help getting through a short-term money crunch.
Money crunches can result from any number of real-life situations, including medical emergencies, new home purchases or college tuition payments. Whatever the reason, the 401(k) loan allows you to borrow the lesser of 50 percent of your 401(k) balance or $50,000 without making a taxable withdrawal. If 50 percent of your account balance is less than $10,000, you can borrow up to $10,000. You can pay the loan back whenever you want. In the meantime, you pay yourself interest. You cannot borrow money from an IRA.
Given the many benefits of 401(k) plans, you may wonder why anyone would want to do an IRA rollover. The primary reason is flexibility. In a 401(k) plan you have a limited menu of investment choices. In an IRA, your menu of investment choices is much broader and can even include investment real estate.
This is where a good financial advisor enters the picture. A good financial advisor can help you decide if the IRA’s additional flexibility is worth giving up ERISA protection. For example, when it comes to retirement income planning, the flexibility of the IRA will allow you to be much more precise as you structure your portfolio to provide the needed income. In time, certain provisions of the new SECURE Act should improve income planning in 401(k) plans, but for now, IRAs are much better.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org