To rollover or not rollover a 401(k) sounds like a simple question. The answer, however, can be quite convoluted. Let's start breaking it down by addressing a few questions you should ask clients prior to rolling over a 401(k).
Has there been a triggering event?
Typically, a triggering event is a separation of service. This could be a retirement, resignation, termination, death, or disability. This could also be a qualified domestic relations order (QDRO) where, in a divorce proceeding, a court orders a portion of a participant's plan to be transferred to their spouse.
Some plans also allow for an in-service distribution where an employee who is over 59½ can transfer funds out of the plan into an IRA.
Absent a triggering event, a rollover may be impossible. The plan may allow for plan loans, which are altogether different and could not be moved to an IRA.
Why is a rollover being considered?
Historically, advisors would look at a 401(k) rollover as low-hanging fruit. However, a rollover to an IRA is not always in the client's best interest. Reg BI makes that point abundantly clear. The advisor has a duty of care to ensure a recommended rollover is in the client's best interest and must consider multiple things like fees, features, and benefits of leaving the money where it is versus moving it to an IRA.
What other assets are there?
For many individuals, their 401(k) may be their largest single asset outside the home. And while a 401(k) rollover must go into an IRA, it does not necessarily have to go into a single product. Strategy and product selection should be based, among other things, on the client's overall portfolio.
For example, a client with a moderate risk tolerance who holds an equal amount outside the 401(k) in certificates of deposit (CDs) or fixed annuities could allocate 100% of the rollover into an equity portfolio, creating a 50/50 (moderate) overall allocation.
But what if the 401(k) is 100% of their investable assets? In that case, care must be taken to allocate the rollover according to the client's risk tolerance and objective, which would most likely be different from the allocation within the 401(k). The client must be educated about the structural differences between an accumulation portfolio and a distribution portfolio.
There is an additional concern if the assets will be going into two different accounts. Most administrators will not send multiple distributions. In this case, it makes sense to set up a brokerage IRA to receive the gross transfer, then transfer out that portion used to fund the non-brokerage portion--an annuity, for example.
Does an in-service distribution make sense?
If your client is still working and over age 59½, their plan may allow for an in-service distribution, which allows them to transfer all or a portion of their 401(k) to an IRA. The plan's summary plan description (SPD) will provide information on what can and cannot be done.
Assuming an in-service distribution is available, it might not always be in the client's best interest. Here are a couple situations in which that may be the case:
- The Rule of 55: Although in most cases a distribution from a qualified plan prior to 59½ will trigger a 10% penalty tax (in addition to ordinary income), the Rule of 55 provision set out by the IRS could eliminate the 10% penalty if used properly. If you leave your job at 55 or older (50 or older for public safety workers), you can take withdrawals from your 401(k) without paying a 10% penalty. The withdrawal itself would still be taxable as ordinary income. If, on the other hand, the funds were rolled over to an IRA, any distributions between 55 and 59½ would incur a 10% tax penalty.
- Would the client possibly need a plan loan? Most 401(k)s allow for plan loans. These loans are tax-free to the participant and are paid back through payroll deduction over time. If funds are moved to an IRA, loans are not available--any withdrawal would be taxable plus a penalty, if applicable.
- Is there an outstanding plan loan? It's best to leave these alone. Trying to instigate a rollover on an account with a loan in place could trigger taxable income to the extent of the loan and possibly a 10% penalty.
- Family dynamics: This one can be touchy. Most qualified plans require the participant's spouse to be the primary beneficiary. It's always a good practice to ensure the “proper” spouse is the named beneficiary—a current as opposed to ex-spouse. Within a 401(k), changes to anyone other than your current spouse would typically require his or her signature. Conversely, changing beneficiaries on an IRA would not have this requirement, so tread carefully in separations or strained relationships.
There are lots of reasons to rollover a 401(k) into an IRA, but you must consider your fiduciary requirements. Most of your choices will cost the client more than leaving it in place. Can you justify that additional cost? Have you thoroughly considered the client's goals and risk tolerance, not just for this account but also for their overall portfolio?
Here are a few advantages an IRA may have over a 401(k):
- Investment choices: The 401(k) may have 20 or 30 mutual funds in which to invest. In an IRA, you and the client will have thousands of investment options.
- Institutional level management: Professional money managers have the three Ts--time, training, and temperament--to manage a portfolio. Most individuals don't have any of the three Ts.
- Guarantees: As a client moves from accumulation to distribution, all the strategies will need to change. Things like dollar cost averaging--which worked so well while growing their account--will work against them if they begin taking systematic withdrawals. A typical 401(k) does not have investment options with underlying guarantees, so an IRA that can provide a guarantee on principal, growth, or income could be invaluable.
- Guaranteed lifetime income: Ask your client, “What portion of your retirement income would you like guaranteed?” Some or all of a 401(k) rollover could be allocated to an annuity to provide a lifetime paycheck throughout retirement.
- Consolidation: Often a client will have numerous 401(k) accounts from multiple former employers. Consolidating to a single IRA simplifies their life and yours. It may also help reduce overall fees and expenses.
Is employer stock involved?
One thing to watch for is a plan that holds employer stock. In some cases, the company will provide a match in the form of company stock. Use extreme caution in these situations. Can the retiree roll the entire plan into an IRA? Of course, but it may be a big tax mistake.
If an employee has a large amount of appreciated company stock in his plan, he may be able to take advantage of the special tax rules on net unrealized appreciation (NUA). NUA is the difference between the original cost basis of the stock and its current market value. The IRS offers a more favorable capital gains tax treatment on the NUA of employer stock, which could be extremely valuable in a large account. NUA transactions are quite tricky and must be handled appropriately to provide this benefit to your client. Be sure to seek qualified advice on one of these transactions.
As you can see, a simple 401(k) rollover may not be that simple after all. And, if your client holds a 403(b) thrift savings plan (TSA), pension, or TSP, there are additional things to consider. Be sure to do your homework or ask for expert advice so you can truly act in your client's best interest.
If you have questions regarding 401(k) rollovers or other retirement strategies, please reach out to your Vice President or call 855.422.4968.