Rolling your 401(k) to a IRA? Think twice

(MoneyWatch) Drive through town these days and you're almost certain to see ads and billboards advising the following: If you quit your job, take that 401(k) balance and roll it over to an IRA.

The implicit message is that your former employer just changed from being the source of your regular paycheck to an enterprise you want nothing to do with. Some financial institutions are even going after 401(k) account holders while they're still employed -- that's because once you reach age 59-1/2, many 401(k) plans let you roll your accounts out from your current employer's 401(k).

So is it a good idea to roll over your 401(k)? Better think twice. Your best bet may be to leave it with your employer.

Minimize fees, keep more money. Large employers are often able to negotiate investment options that drive management fees into the ground. Lower investment management fees mean you get to keep more retirement savings. Combine those low fees with a passive investment approach, and you've got a "passive" strategy that's been demonstrated by my fellow CBS MoneyWatch bloggers Larry Swedroe and Allan Roth to consistently outperform actively managed funds.

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Before you make a move, compare the fees of your 401(k) plan's funds with any retail funds you're considering at the IRA rollover institution. The new 401(k) fee-disclosure rules that become fully effective in August will make this comparison easier. My recent post showed average and median fees for various types of mutual funds. You'll want to invest in funds with expenses well below these averages, and there's a good chance your 401(k) plan will accomplish this.

Better service. Employers often negotiate special services for their 401(k) plan participants, including access to planning tools, dedicated 'help' phone lines, investment advice, and educational workshops. These are also typically available to former participants and retirees. Often, you wouldn't be able to get all of these services as a retail IRA customer.

Retirement income options. As I mentioned in a previous post, more employers are considering implementing innovative retirement income options in their 401(k) plans to help plan participants generate lifetime retirement income. These offerings often have lower costs and fewer bells and whistles than comparable retail products -- that can make them cheaper and easier for you to manage.

Beware of the required minimum distribution rules. Once you reach age 70-1/2, the IRS rules for required minimum distributions (RMD) require you to withdraw minimum amounts from your IRA or 401(k) account. However, there's an important exception that might prove to be valuable; it's only available with 401(k) plans and not with IRAs. If you're still working at age 70-1/2, you typically don't need to comply with the RMD rules for any 401(k) accounts you hold with your current employer. (Note: Certain highly paid individuals aren't eligible for this special exception.)

A few years ago, a mutual fund company representative convinced a friend of mine to roll her 401(k) accounts to that mutual fund company. The rep convinced her that she'd enjoy "greater investment flexibility" if she did so. She's still working for the same employer, and now she's reached age 70-1/2. She's angry because she's forced to make minimum withdrawals that are included in her taxable income. This wouldn't be happening if she'd left her accounts with her employer's 401(k) plan, which, by the way, offers the low-cost investment options described above.

Take special care with company stock. If your 401(k) accounts have substantial amounts invested in your company's stock, then you'll need to pay particular attention to the rules regarding net unrealized appreciation (NUA). You might want to pay taxes now on the amount of your company stock and only roll over to an IRA the amounts not held in company stock. If you have substantial company stock in your 401(k) plan, you'll want to consult a tax accountant to see if you can take advantage of the NUA rules. If you leave your accounts in your employer's 401(k) plan, you won't need to deal with these issues until you eventually withdraw the amounts attributable to company stock.

There is one instance where it makes sense to move your money from your employer's 401(k) plan, and that's when it's clear you can get investments with much lower fees with the IRA rollover. This often happens with smaller employers that couldn't negotiate better deals for their employees and that pass along the 401(k) plans' administrative expenses to their employees.

Here's the bottom line for me: Most employers spend a lot of time and money designing their 401(k) plans to help their employees. They don't make money from their 401(k) plan, and in fact it often costs the business to have this program in place. By contrast, any financial institution you'll be dealing with needs to make a buck (or lots of bucks) off of your investments. Which option sounds better to you?

[Alskar]

Hi Steve,

You bring up several good points, but I just have to ask where all of these employer's are that have well managed, low-expense, 401(k) plans with "innovative retirement income options"? I've participated in eight 401(k) plans so far, and I make it a practice rollover my money out of my previous employer's 401(k) plan and into a rollover IRA as soon as the paperwork can be processed.

A typical 401(k) plan offered to high-tech workers has funds with expense ratios from 0.80% for an S&P 500 fund up to 2% for an actively managed international fund. On top of that there is often a 5-15 bps "management fee" that is taken out every quarter.

Employers are NOT running their 401(k) plans for the "sole benefit of their employees" as required by law. They are doing everything they can to minimize the cost of these plans by forcing the cost of administering the plans off on the employees by choosing funds that give the best under-the-table kickbacks in the form of "revenue sharing".

So while I see your point about RMD's I have yet to experience a 401(k) plan that was truly run for the benefit of the employees as required by law. Google "Tussey v. ABB" for a recent example of the type of criminal activity that accompanies a typical 401(k) plan.

I also got a chuckle when I read your comment about getting better service at a 401(k) provider. That has NOT been my experience. Typically, the annual 401(k) presentation put on by a 401(k) administrator consists of a pathetic description of what dollar-cost-averaging means followed by the presenter actively trolling for new financial planning customers. Merrill Lynch is the worst-of-the-worst in this regard.

Having said that, I think there are two other benefits of keeping one's money in a 401(k) instead of rolling it over into an IRA: 1) Money in a 401(k) is protected in a bankruptcy and 2) one can take a loan against a 401(k) balance (probably not a good idea, but possible).

[Alskar]

Hi Steve,

You bring up several good points, but I just have to ask where all of these employer's are that have well managed, low-expense, 401(k) plans with "innovative retirement income options"? I've participated in eight 401(k) plans so far, and I make it a practice rollover my money out of my previous employer's 401(k) plan and into a rollover IRA as soon as the paperwork can be processed.

A typical 401(k) plan offered to high-tech workers has funds with expense ratios from 0.80% for an S&P 500 fund up to 2% for an actively managed international fund. On top of that there is often a 5-15 bps "management fee" that is taken out every quarter.

Employers are NOT running their 401(k) plans for the "sole benefit of their employees" as required by law. They are doing everything they can to minimize the cost of these plans by forcing the cost of administering the plans off on the employees by choosing funds that give the best under-the-table kickbacks in the form of "revenue sharing".

So while I see your point about RMD's I have yet to experience a 401(k) plan that was truly run for the benefit of the employees as required by law. Google "Tussey v. ABB" for a recent example of the type of criminal activity that accompanies a typical 401(k) plan.

I also got a chuckle when I read your comment about getting better service at a 401(k) provider. That has NOT been my experience. Typically, the annual 401(k) presentation put on by a 401(k) administrator consists of a pathetic description of what dollar-cost-averaging means followed by the presenter actively trolling for new financial planning customers. Merrill Lynch is the worst-of-the-worst in this regard.

Having said that, I think there are two other benefits of keeping one's money in a 401(k) instead of rolling it over into an IRA: 1) Money in a 401(k) is protected in a bankruptcy and 2) one can take a loan against a 401(k) balance (probably not a good idea, but possible).

[rightbehind]

I didn't have to think twice. I was glad to get my money out of wall street before they looted it. Most all of the money there was money I put in. I avoided loans from commercial banks and made loans to myself from that 401K. The interest collected went to me. Now it sits in a FDIC insured IRA. I could care less now about what wall street is doing.

Capitalism works great on other peoples money. As for me the wealthy will have to spend their own.