Financial Tip #6: Rollover 401(k) assets to IRAs

Employees changing jobs with funds in a high-cost 401(k) need to consider rolling funds into a low-cost IRA.

Tip #6: An employee leaving a firm can substantially increase retirement wealth by moving401(k) funds to an IRA.   Be careful though!  Protections against creditors are stronger for 401(k) plans than for IRAs in many states.

Examples of potential gain from rolling over assets in a high-cost 401(K) to a low-cost IRA

Example One:  A worker leaving her firm at age 50 can keep $500,000 in 401(k) funds in the firm-sponsored retirement plan that charges an annual fee of 1.3% or can move the funds to a low-cost IRA that charges an annual fee of 0.3%.   The return on assets prior to fees in both the 401(k) plan and the IRA is 6.0 percent per year.  

What is the value of the account at age if assets remain in the high-cost 401(k) and if assets are rolled over into the low-cost IRA?

  • Account value of high-fee 401(k) plan is $995,796.
  • Account value of low-cost IRA is $1,148,404.
  • Gain from rollover is $152,609.

Example Two: A worker changing jobs at age 30 can keep $20,000 in the firm 401(k) or move the funds to a low-cost IRA.  The annual fee for the 401(k) is 1.3 %, the annual fee for the IRA is 0.3%. The underlying returns prior to fees for both assets in the 401(k) and assets in the IRA is 8.0%.  

What is the value of the account at age 60 if the person keeps assets in the high-cost 401(k) or moves funds to a low-cost IRA?

  • Account value of high-cost 401(k) plan is $139,947.
  • Account value of low-cost IRA is $185,140.
  • Gain from rollover is $45,194.

Note: The impact of financial fees on the future value of the account can be calculated with the FV function in Excel.  The arguments of the FV function are the rate of return after fees, holding period in years, and the initial balance in the 401(k) plan.   

 Additional Comments:

  • Most roll overs from 401(k) plans to IRAs occur when a worker leaves a firm for another employer.  Some firms allow for some in-service rollovers.  
  • Some workers, in need of cash routinely, disburse funds from their 401(k) plan.  The disbursement of funds from a traditional 401(k) plan prior to age 59 ½ can lead to penalties or tax.   A roll over of funds from a 401(k) plan does not lead to additional tax or any financial penalties.
  • One motive for moving funds from a 401(k) plan to an IRA is the desire to place funds in a Roth account when a firm only offers a traditional retirement plan.   The act of rolling over funds from a 401(k) to an IRA and the act of converting the new conventional IRA to a Roth IRA are separate and do not have to occur together.  Conversion costs are lowest when a worker has low marginal tax rate.  Several future posts will examine the costs and benefits on converting traditional retirement accounts to Roth accounts.
  • The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy.  Whether IRAs are protected from creditors is determined by state law.  ERISA, a national law, provides protection against creditors for 401(k) plans.  This difference can persuade some people to keep funds in a 401(k) plan, rather than covert funds to an IRA.  Go here for a state-by-state analysis of protections against creditors for owners of IRAs.
  • The calculations, presented above, of greater wealth from the rollover assumes identical pre-tax returns for the high-cost 401(k) plan and the low-cost IRA.  Most financial experts believe that low-cost passively managed funds tend to outperform high-cost funds.  Interestingly, Warren Buffet, probably the best active investor of all times suggests passive investing in low-cost funds is generally the better approach.
  • Factors other than transaction costs can impact the decision to rollover 401(k) funds or stay.   Some 401(k) plans allow investors to purchase an annuity at retirement.  The existence of automatic enrollment from a 401(k) plan to an annuity could induce some workers to keep funds in a 401(k) rather than roll over funds into an IRA.

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