401(k) Rollover Guide: Should You Stay or Should You Roll?

When you leave an employer, one of the most important financial decisions you'll face is what to do with your retirement savings. Should you leave your 401(k) with your former employer or roll it over into an IRA? This guide explores the pros and cons of both options to help you make an informed decision.

Option 1: Leave Your 401(k) With Your Former Employer

Pros

• Simplicity: Keeping your money where it is requires no immediate action.
• Unique Investment Options: Some employer plans offer institutional-class funds or other investments that aren't available to individual investors.
• Strong Creditor Protection: Employer plans typically provide superior protection from creditors under federal law (ERISA).
• Loan Options: Many employer plans allow you to borrow against your balance, a feature not available with IRAs.

Cons

• Higher Fees: Employer plans often have higher administrative fees than what you might pay with an IRA.
• Changing Rules: Your former employer can modify the plan rules or change investment options without your input.
• Account Management: Having retirement funds scattered across multiple former employers can make tracking and managing your retirement assets more difficult.
• Missed Opportunities: You might miss a "triggering event" opportunity, such as using Net Unrealized Appreciation (NUA) strategies for employer stock (see details on NUA below).

Option 2: Roll Over to an IRA

Pros

• Investment Flexibility: IRAs typically offer a much wider range of investment options compared to the limited menu in most 401(k) plans.
• Account Consolidation: Rolling over helps simplify your financial life by consolidating retirement accounts in one place.
• Roth Conversion Flexibility: IRAs typically provide more flexibility for Roth conversions (though some employer plans now offer this option as well).
• NUA Opportunities: If your 401(k) includes highly appreciated company stock, taking a lump-sum distribution and rolling over the non-company stock portion of your 401(k) might allow you to take advantage of Net Unrealized Appreciation tax strategies at a triggering event like separation from service (see details on NUA below).

Cons

• No Loan Options: Unlike 401(k)s, IRAs don't allow you to borrow against your balance.
• Reduced Creditor Protection: While IRAs do have some creditor protection, it's generally not as strong as what's provided by ERISA for 401(k) plans.
• Pro-Rata Rule Considerations: Mixing pretax and after-tax contributions can trigger the "pro-rata rule" during distributions or conversions, potentially increasing your tax liability (especially important if you're considering backdoor Roth contributions). Before you roll - see if you are impacted. Options to prevent mixing funds - do a Roth Conversion on the after-tax IRA contributions before rolling over pre-tax IRA contributions. The key is, you don't want to mix if you can avoid it.

Which Option Is Right for You?

As with most financial decisions, the best choice depends on your personal circumstances and financial goals. Consider researching:

• Your current plan's investment options and fee structure compared to an IRA
• Whether you need professional guidance in selecting investments
• Your creditor protection needs
• Whether your former employer even allows you to keep your 401(k) there (some require distribution upon termination)
• Your age. Considerations for using the NUA tax strategy may be impacted by your current age and the appreciation of the stock past your cost basis.

How to Roll Over Your 401(k) to an IRA

If you decide a rollover is right for you, here's how to proceed:

1. Open an IRA Rollover Account: Choose a custodian (like Schwab, Vanguard, or Fidelity as examples) and open an IRA rollover account if you don't already have one.

2. Contact Your Benefits Administrator: Inform your former employer's benefits department about your desire to distribute your 401(k) to your new custodian.

3. Choose Your Transfer Method: You may have options for how your assets transfer:

   • Direct Transfer: Assets move directly from one custodian to another (preferred method)
   • In-Kind Transfer: Some plans allow you to transfer your actual investments without selling them (required for NUA strategies)
   • Cash Transfer*: Your investments are sold and cash is transferred to your new account

4. Reinvest Your Funds: Once the funds arrive at your new custodian, if applicable, select your investments based on your financial goals and risk tolerance.

*Note: Even if you temporarily receive the distribution check, you have 60 days to deposit it into your rollover IRA without tax consequences. However, a direct custodian-to-custodian transfer is usually simpler and eliminates any risk of missing this deadline.

Understanding Key Terms

Net Unrealized Appreciation (NUA): A tax strategy that allows you to pay ordinary income tax only on the cost basis of employer stock in your 401(k), while paying the lower capital gains tax on the appreciation when you eventually sell the shares. This option is only available when you have a "triggering event" - separation from service, turning 59 ½ years old, or death. These shares will be distributed to a regular brokerage account and you will pay the income tax on your cost basis. When you decide to sell the stock, you will pay long-term capital gains tax on the appreciated value only. Keep in mind, if you are under 55 years of age when you separate from service, you will face a 10% early withdrawal penalty - however, it still may be worth the penalty than rolling the entire amount over to an IRA and pay income tax on the entire amount later. Speak with a financial advisor or tax specialist to weigh your options.

Pro-Rata Rule: When you have an IRA with post-tax contributions (you paid the tax on the contributions already) you want to avoid adding pre-tax contributions to the IRA because you cannot withdraw your post-tax contributions tax free (except gains) due to the pro-rata rule. When you have both pre-tax and after-tax money in IRAs, you cannot choose to withdraw or convert only the after-tax portion. Instead, each distribution is treated as coming proportionally from both pre-tax and after-tax funds, potentially creating unexpected tax consequences.

This blog post is intended for educational and informational purposes only. The views expressed are solely those of the author and do not represent professional financial advice. While every effort has been made to ensure the accuracy of the information presented, it should not be relied upon as a substitute for individualized advice from a qualified financial advisor. Financial decisions are complex and personal, and readers are strongly encouraged to conduct their own due diligence and seek professional guidance before making any investment or financial planning choices.