Rethinking 401(k) Rollovers

7 things to consider before you move your nest egg into an IRA.

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Conventional retirement wisdom tells us that when you leave a job, you should roll over your 401(k) to an IRA. Rollovers allow you to continue delaying taxes on your nest egg as it accumulates and avoid an early-withdrawal penalty. But if you have an especially good 401(k) with your old company, it may be better to leave your retirement money there or roll it over into your new company's 401(k).

Here's how to decide if a 401(k) rollover to an IRA is right for you.

Consider fees. Americans transferred $195 billion from 401(k)-type plans to IRAs in 2006. But rollovers are a wise move for retirement savers only if the IRA charges lower fees than the 401(k) plan at the old or new job. Sometimes the IRA is a better deal, especially if the 401(k) is through a small business. But large companies often negotiate institutionally priced investments with lower costs than individuals can get on their own from retail IRAs. Low expenses make those 401(k)'s a much better place to keep your nest egg.

Rolling over a 401(k) to a high-priced IRA can cost you dearly, according to Hewitt Associates, a human resources consulting firm that processed more than 150,000 rollovers in 2006. A 35-year-old employee who changes jobs and leaves behind $33,000 in a 401(k) with typical institutionally priced investments can expect to have squirreled away $404,105 by age 70, according to Hewitt. If the same employee rolled the balance into a typical retail IRA (assuming in both cases an 8 percent annual return before fees are subtracted), he would have only $366,424 at 70. That's a difference of $37,681.

"If you have under $100,000, even the token IRA fees and commissions of $15, $30, or $50 add up," says Steven Dimitriou, a financial adviser and managing partner at Boston's Mayflower Advisors.

Scrutinize investment options. IRAs almost always have more investment choices than 401(k)'s. "The pro for rolling it over into an IRA is diversification," Dimitriou says. "In an IRA, you can invest in individual stocks, bonds, and any mutual fund you want to." Savvy investors who already know they prefer low-cost index funds over exchange-traded funds, or vice versa, will enjoy the freedom of an IRA.

But retirement savers who aren't likely to peruse their mutual fund prospectus might enjoy a smaller array of options already vetted by their employer or plan sponsor. "Someone has limited the choices to a reasonable number and done a screen for you," says David Wray, president of the Profit Sharing/401(k) Council of America. "If you are satisfied with the investments that you have, then you might want to leave [your money] there."

Avoid transfer penalties. If you are going to move your 401(k) to an IRA or your new 401(k) plan, you need to watch out for penalties. Job-hoppers can save themselves a lot of trouble—and money—by having the former employer send the cash directly to the new financial institution. "You can do unlimited direct rollovers on an annual basis," says Paul Burkemper, a registered investment adviser and president of Burkemper Group in St. Louis.

If you take the old 401(k) into your own hands, your employer will cut you a check for the balance, minus 20 percent withholding for income taxes in case you decide to keep the money. Then, you generally have 60 days to put the cash into a qualified tax-deferred account. If you don't, Uncle Sam will keep the 20 percent (plus any additional amount you owe at tax time). This also means you have to come up with the absent 20 percent from another stash if you want to roll all of the distribution into an IRA. Only one rollover in this manner is allowed every 12 months.

Don't relocate employer stock. Stock of the company you work for gets special tax treatment when held in an employer-sponsored 401(k). "If there's employer stock inside the 401(k), you may want to not roll that portion into an IRA," Burkemper says.

Here's an example: An employee buys $100,000 worth of company stock in his 401(k) plan, and it grows to be worth $1 million. If that stock is rolled over to an IRA, when it's withdrawn, it will be taxed as ordinary income at a rate of up to 35 percent. Instead, Burkemper recommends that workers consider withdrawing the stock from the retirement plan. The original $100,000 investment would be taxable as ordinary income in the year of the distribution. But there is no tax on the $900,000 stock appreciation until it is sold. And then it would be taxed at the long-term, capital-gains rate of 15 percent. That would save the hypothetical borrower in this example $180,000 in taxes, assuming that income and capital-gains tax rates stay the same. "If you roll it over to the IRA, that tax benefit is gone," Burkemper says.