What to know before rolling a 401(k) to an IRA.

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Many factors should be considered before rolling a 401(k) account to an IRA.  One of the key factors to consider is that distributions from a 401(k) may be taken penalty-free if the employee separates from service in the year in or after he or she turns 55 – and the plan provides for it. On the other hand,  once a 401(k) account has been rolled into an IRA, any distributions from that IRA before age 59 ½ - except in certain circumstances - will be assessed a 10% early withdrawal penalty, in addition to state penalties.

But many 401(k) plans provide for penalty-free withdrawals if the employee separates from service in or after the year he or she turns 55, offering an opportunity for those who wish to take penalty-free distributions from their 401(k) before reaching age 59 ½  However, some 401(k) plans only provide for a one-time lump-sum distribution from the plan once the employee has terminated service.  And while a lump-sum distribution in such cases would avoid the 10% early withdrawal penalty, it would still result in the entire amount being taxed as ordinary income unless it was rolled into an IRA or other 401(k) plan.

Besides the above, there are many other factors to consider:  

  • Ease of estate planning:  Some 401(k) plans have restrictive rules that affect estate planning.  For example, some 401(k) plans do not permit a beneficiary to name a successor beneficiary. There may also be restrictions on beneficiary designations, or with post-death splitting of the account.   By rolling into an IRA, 401(k) plan rules no longer apply, providing more control for the owner and ultimately for the heirs.   
  • Higher 401(k) expenses.  Many 401(k) plans include higher-priced mutual funds which can easily result in annual plan expenses of 1.5% or more.  In an IRA, ultra-low cost Vanguard or other index funds can be purchased at 70-90% less cost, though the owner may need to obtain professional investment advice.
  • Asset Protection:  Qualified Retirement Plans such as 401(k) plans are governed by federal law and generally provide greater protection from creditors than do IRA’s, which are governed by laws that vary from state to state.   When a 401(k) is rolled into an IRA, superior protection from creditors may be obtained if that IRA contains only funds rolled over from a 401(k) - and no other contributions.
  • Spousal Issues: Under federal law, spouses generally have greater rights to 401(k) plan assets than to IRAs, which are governed by state law that largely depends on whether that state is a community property state.  For example, a waiver of a spousal right to a 401(k) account in a prenuptial agreement is unlikely to be valid, since federal law explicitly requires a waiver from an actual “spouse”.  In such cases, only a post-nuptial waver is likely to be valid. 
  • 401(k) plans may provide greater Roth conversions opportunities for non-spouse beneficiaries: Under current law, a non-spouse beneficiary cannot convert an Inherited IRA to an Inherited Roth IRA. However, current law does permit beneficiaries to convert an inherited 401(k) plan to either an inherited IRA or an inherited Roth IRA.