Misconceptions When Considering a 401k Rollover

You happen to be approaching retirement and ready to get pension payments and tap your retirement accumulations. What do you need to do with those contributions you made as well as your employer matches to your 401(k)? Do you need to do a 401k rollover?

You essentially have two possibilities. It is possible to maintain your assets in the employer plan or decide to perform a 401k rollover. The first consideration in favor of the 401k rollover is increased investment options. rather than a menu of 4 to 6 funds, typical for a 401k plan, a self directed IRA has virtually no restrictions on investments. So it could be a mistake to leave funds in a 401k plan because its easy. You may be sacrificing choices and investment returns.

The next misconception or lack of understanding is that you don't pay any fees on your funds in the 401k. That is not accurate and in fact, at the time of this writing, the department of Labor is finally working on regulations to limit and improve disclosure of 401k fees. Between investment management fees, 12b-1 fees, mortality expense (if your employer was foolish enough to have the 401k plan consist of annuity contracts), you could be losing 4% annually off the top. Once you complete a 401k rollover to a self-directed IRA, using no-load funds, you expenses will drop to less than .5%, an 80% savings.

Next is the issue of IRA creditor protection. Should you have financial problems, your IRA may or may not be protected from creditors. It depends on your individual state laws. However, money in a 401k plan or other ERISA plan is creditor protected by federal law. The protection applies no matter where you live in the US. This is one potential argument not to do a 401k rollover.

Another issue comes into play if you have shares of your employer's stock in your 401k. You likely will not want to include these as part of your 401k rollover. That's because special tax rules apply (the net unrealized appreciation provision) that tax the gain on these shares at capital gains rates, which is preferable to ordinary income rates.

Last is the issue of potential penalties if under age 59 1/2. If you perform a 401k rollover and later need to withdraw funds from your IRA and are under age 59 1/2, then a 10% penalty applies (barring you do not qualify for one of the exceptions). However, if you have separated from service from an ex-employer, you may take withdrawals from that 401k as early as age 55 without penalty. This potentially is another reason to forgo the 401k rollover.

If you need assistance in making these decisions, then consult a financial or tax professional.