The Wall Street Journal
By: Carolyn Geer
August 2, 2010
When changing employers, many workers leave money in the company retirement plan. But moving the dollars to your new firm or an IRA might be a better deal. Here's how to decide.
Financial planner Rick Brooks increasingly finds himself tangling with what he and his colleagues call "yapping dogs." Not the canine variety, but the 401(k) type--those pesky retirement accounts many people leave behind in their ex-employers' 401(k) plans when they change jobs.
Mr. Brooks, who works for Blankinship & Foster LLC in Solana Beach, Calif., says he has clients with three such accounts each. Depending on the number of jobs a person has had and the type of accounts held at each one, "you can quickly get to an entire kennel," he says.
These old 401(k) accounts can be minor annoyances, increasing a person's financial paperwork and making it tougher to view one's portfolio as a whole. Others are downright dangerous, taking a big bite out of overall investment returns with their high costs.
All told, there are 15 million yapping-dog accounts in the U.S. retirement system, according to David Wray, head of the Profit Sharing/401k Council of America, an association of companies that sponsor retirement plans. And millions more are in the making, he says, as more people enroll--or are automatically enrolled--in their employers' 401(k) plans.
Moreover, the bulk of these accounts aren't Chihuahuas. They're Great Danes. In a study by human-resources consultants Hewitt Associates Inc., only 3% of departing employees with accounts of less than $1,000 left their money in their former employers' plans, while nearly half of those with balances of $100,000 or more did so. That's partly because many companies don't allow departing employees with very small accounts to stay in their plans.
While leaving money in an old 401(k) plan is sometimes a smart move, experts say the primary reason people don't take these accounts with them when they change jobs is inertia. There also is confusion about the options, or--to push the canine metaphors one last time--whether to walk, stay or roll over.
Cashing out a 401(k) account is rarely a smart idea. Typically, you face income taxes on the distribution, a 10% penalty if you are younger than 59½ years old, and 20% withholding--plus you give up the opportunity for continued tax-deferred or tax-free compounding of your assets.
The more complex decision is whether to stay in the current plan or roll the money over into either a new employer's plan or an individual retirement account. While new employers aren't required to accept such rollovers, most do. Here are key considerations:
All else being equal, the lower a plan's costs, the faster your money will grow. If your ex-employer is small, you probably are paying higher-than-necessary fees and should get out.
A study by the Investment Company Institute trade group found that the median all-in fee--which includes record-keeping, administrative and investment-management charges--was 0.72% of assets annually across all plans. But among plans with less than $1 million in assets, the median fee was 1.89%, compared with less than 0.5% for plans with more than $500 million in assets. Larger plans are more likely to offer investment options with lower expense ratios, such as institutional shares of mutual funds.
Still, bear in mind that more and more employers are charging ex-employees account-maintenance fees ranging from a few dollars per year to more than $100 per year, according to Hewitt. One hundred dollars on a $2 million account may be no big deal, but on a $5,000 account it's a steep 2% that could offset any savings in investment-management costs.
Fee disclosure is notoriously murky in the 401(k) world, something the Department of Labor is working to address. If your plan fees--including fund expense ratios and any additional charges--aren't clearly detailed on your account statement, inquire with the employer's benefits department. If you can't get a straight answer, transfer the account.
IRA marketers will tout the fact that you will have more investments to choose from in an IRA than in a 401(k). But more isn't necessarily better. "A well diversified portfolio does not need 50 options," says Stephen Utkus, director of Vanguard Group's retirement research center. "You can do it with a few good choices."
Most 401(k) plans offer a choice of stock, bond and cash investments, and many have sophisticated committees selecting the options and monitoring their performance. Check the menu at your old and new plans and use resources like Morningstar.com and this newspaper's mutual-fund data--at WSJMarkets.com--to see how funds have performed versus peers.
Sometimes a 401(k) plan will offer a unique investment that isn't available in the retail market. Steve Fisher, a financial planner in Traverse City, Mich., has a retiree client who would like to roll his old 401(k) account into an IRA and have Mr. Fisher manage it. But the 401(k) plan offers a "stable value" investment option paying a guaranteed 2.75% annualized interest. Stable-value funds hold a portfolio of bonds and also have financial backing from a bank or insurer that is intended to protect investors from any losses.
"This would be difficult to duplicate in a short-term investment outside his 401(k)," Mr. Fisher says. So Mr. Fisher is advising the client, a conservative investor, to postpone the rollover and invest in the stable-value fund.
Be aware that 401(k)s and IRAs have different withdrawal rules. With some exceptions, assets in traditional IRAs need to be left alone until you turn 59½ to avoid the 10% penalty tax on early withdrawals. Exceptions include withdrawals for first-time home purchases or education, in which case only ordinary income tax would apply.
But, if you are 55 or older when you leave your job or are laid off, you may be able to take penalty-free withdrawals from your 401(k). Again, the withdrawals would be subject to ordinary income tax.
David Mayes, a financial adviser in Hampton, N.H., has a client who was laid off at age 56. He recommended the client not roll his 401(k) account into an IRA so those funds would be available penalty-free if needed after his severance pay ran out.
Other access provisions may be more important to younger job changers. For example, most 401(k) plans offer loans to current employees, meaning they can borrow against their account value and repay it, with interest, without incurring taxes or penalties.
Older people may have different concerns. Some 401(k) plans allow only lump-sum withdrawals. So, if you are 65 and want to take some money from your account, or are older than 70½ and must start taking required minimum distributions as per the law, you may have to roll your entire account into an IRA. Some employers, says Vanguard's Mr. Utkus, are definitely of the view that if you need the money, you need to find a new home for your 401(k) account.
The Roth Option
If you roll your account into a new employer's plan or into a traditional IRA, you postpone paying tax on the money. You may also want to consider a very different option: converting that retirement-plan account to a Roth IRA.
With a Roth, your future withdrawals can be tax-free, in contrast to withdrawals from a regular IRA, which are taxable. But you will have to pay income tax upfront on any previous pretax contributions and earnings you roll into a Roth, which for most people will be their entire account balance.
Converting may be attractive if you expect to be subject to higher tax rates in retirement than now. But it's a complex decision, so consider getting professional advice, especially if your 401(k) account is large.
Starting this year, you can roll your 401(k) account into a Roth IRA no matter what your annual income. Previously, those who made more than $100,000 a year were prohibited from doing so.
If you are considering a 401(k)-to-Roth IRA rollover, this may be a good year to do it because special rules allow you to include half of the taxable income on your 2011 tax return and the other half on your 2012 return, decreasing the chance that the conversion will push you into a higher tax bracket.
Meanwhile, some advisers warn against rolling an old 401(k) account into a traditional IRA if you intend to convert that IRA to a Roth IRA.
Ryan Thomas, a financial adviser in Indianapolis, recently counseled a client to keep an old 401(k) intact rather than roll it into his traditional IRA to save taxes on a conversion. The client had funded the IRA over several years with nondeductible contributions. Had he rolled his old 401(k), containing pretax contributions, into his IRA, a greater percentage of the conversion would have been taxable. "Therefore," concludes Mr. Thomas, "the impact of rolling a 401(k) to an IRA has to be considered for anyone contemplating a Roth conversion."
Ms. Geer is a writer in Fairfield, Conn. Email her at email@example.com.