Should You Rollover Your Dormant 401(k) to an IRA?

If you’ve recently changed jobs or retired, you might have a dormant 401(k) sitting with a previous employer. Deciding whether to leave it where it is or roll it over into an Individual Retirement Account (IRA) is an important financial decision that can impact your retirement planning. While there’s no one-size-fits-all answer, understanding the pros and cons of each option can help you make the right choice for your situation.

Here’s a breakdown of key considerations to guide you through this decision.

The Benefits of Rolling Over Your 401(k) to an IRA

1. More Investment Options
   401(k) plans typically offer a limited selection of funds, often focused on large-cap stocks or target-date funds. With an IRA, you gain access to a wider range of investment options, including individual stocks, bonds, ETFs, and mutual funds. This can allow for more diversification and control over your retirement portfolio.
2. Consolidation and Simplification
   By rolling over your dormant 401(k) into an IRA, you can consolidate multiple retirement accounts into one. This simplifies managing your assets, reduces paperwork, and makes tracking your investments and required minimum distributions (RMDs) easier once you reach the appropriate age.
3. Potentially Lower Fees
   Some 401(k) plans charge high administrative fees, which can erode your investment returns over time. IRAs, especially those held with low-cost brokerages, may offer lower account and investment management fees, potentially saving you money in the long run.
4. Greater Control Over Withdrawals
   With an IRA, you generally have more flexibility in how and when you take withdrawals, whereas some 401(k) plans have restrictions on withdrawal options, including penalties for taking distributions before age 59½. An IRA may provide more tailored withdrawal strategies that can align with your retirement income needs.
5. Roth IRA Conversion Opportunity
   If you’re looking to diversify your tax strategy, rolling over your 401(k) into a traditional IRA opens the door to converting those funds into a Roth IRA later. This can be beneficial if you expect to be in a higher tax bracket in the future or want the advantage of tax-free withdrawals during retirement. While some 401(k) plans do allow for Roth conversions within the plan, many do not, so it’s important to check your specific plan’s rules before making any decisions.

Reasons to Keep Your 401(k) with Your Previous Employer

1. Creditor Protection
   One of the biggest advantages of leaving your 401(k) with your former employer is the stronger creditor protection it offers under the Employee Retirement Income Security Act (ERISA). While IRAs have some protections, 401(k) plans are generally more shielded from creditors in cases of bankruptcy or legal judgments.
2. Access to Institutional Investments
   Some 401(k) plans offer access to institutional funds with lower expense ratios than you might find with retail funds available in an IRA. If your former employer’s 401(k) plan has high-quality, low-cost investment options, it might be worth staying put.
3. Early Withdrawal Flexibility
   If you leave your job after age 55 but before age 59½, you can take penalty-free withdrawals from your 401(k). With an IRA, you’d have to wait until 59½ to avoid early withdrawal penalties unless you qualify for an exception.
4. Loans May Still Be Available
   Some 401(k) plans allow participants to take loans against their balance. IRAs, however, do not offer this option. If you think you might need to borrow from your retirement funds before retirement age, keeping your 401(k) with your previous employer may be a better choice.

Key Tax Considerations

When rolling over a 401(k) to an IRA, it’s important to ensure it’s done correctly to avoid unintended tax consequences. A direct rollover (trustee-to-trustee transfer) ensures your funds move from the 401(k) to the IRA without triggering taxes. If you opt for an indirect rollover, where you take possession of the funds before reinvesting them into the IRA, you’ll need to complete the rollover within 60 days to avoid taxes and potential penalties.

Additionally, keep in mind that if you have company stock in your 401(k), you might qualify for favorable tax treatment under Net Unrealized Appreciation (NUA) rules.

So, Should You Roll Over Your Dormant 401(k) to an IRA?

The decision ultimately comes down to your personal financial goals, investment preferences, and specific needs. If you prioritize flexibility, more investment choices, and the potential for lower fees, rolling over to an IRA might be a better fit. However, if you value creditor protection, lower-cost institutional investments, or access to penalty-free early withdrawals, keeping your 401(k) with your former employer could be the right move.

Before making any decisions, it’s wise to consult with a financial advisor to evaluate your options based on your retirement plans and financial circumstances. Rolling over a dormant 401(k) into an IRA can be a great opportunity to enhance your retirement strategy, but only if it aligns with your long-term goals.

If you’re unsure of what to do, don’t hesitate to reach out. As a fiduciary advisor, I can help you navigate the complexities of this decision without the influence of commissions or sales pressure.

Additionally, to help you better understand whether rolling over your dormant 401(k) to an IRA is the right move, I’ve posted the below flowchart that walks you through the decision-making process. This visual guide will take you step-by-step through the key factors to consider, including your investment options, tax implications, and long-term retirement goals.

Disclaimer:

The information provided in this financial planning post is intended for general informational purposes only and should not be construed as personalized financial, investment, tax, or legal advice.

Financial planning is a complex and highly individualized process that takes into account your unique financial situation, goals, and risk tolerance. While this post aims to provide useful insights and guidance, it is not a substitute for professional advice tailored to your specific circumstances. We strongly recommend that you consult with a qualified financial advisor, tax professional, or legal expert before making any financial decisions or implementing any financial strategies. Any decisions made based on the information in this post are solely at your own risk.