Wall Street has done a remarkably thorough job of brainwashing investors into rolling their old 401(k) accounts into individual retirement accounts.
IRA rollovers are certainly a better option than cashing out, which is the stupidest thing you can do with a 401(k) account other than not fund it in the first place. But moving money from a workplace retirement plan to an IRA when you switch jobs or retire can be a really lousy idea.
“In most cases, it’s not the best decision for retirement investors,” says investor protection expert Micah Hauptman, who serves as financial services counsel at the Consumer Federation of America. “But rollovers are a huge profit source for all financial services firms.”
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Here’s what those financial firms are telling you, and why you should think twice before listening:
“You’ll have more investment options.” Yes, and you’ll likely pay more for them — at least 30% more, based on asset-weighted averages for stock funds inside 401(k)s versus outside. The gap may be even wider, since large-company 401(k) plans typically have access to ultra-cheap institutional funds.
“You can consolidate your accounts.” Yes, you don’t want to leave old 401(k) accounts scattered behind you as you leap from job to job to job. You’ll likely pay too much in fees, and it’s hard to coordinate investments across multiple accounts. But if your current employer’s plan accepts transfers — and many do — that may be a better option than an IRA rollover.
“You’ll have more control.” Yes, if you’re a sophisticated investor with a nuanced understanding of asset allocation, more control can be a good thing. But you may just be a good target for a sales pitch. Your friendly financial services firm could steer your IRA investments toward high-commission options such as mutual funds with sales fees, variable annuities and nontraded real estate investment trusts.
Investments that come with such built-in conflicts of interest make up more than 20% of assets held in IRAs, according to the White House Council of Economic Advisors. People who receive conflicted advice when rolling over 401(k) balances to IRAs at retirement could run out of money five years earlier than those who don’t, the economists said.
Financial services companies don’t have to put your interests first — at least not yet (more on that in a moment). Your 401(k) plan sponsor, on the other hand, does have the fiduciary obligation to act solely in the best interest of plan participants and their beneficiaries. So you may not have as many investment options, but they’re likely to be better choices than whatever happens to pay your broker the highest commission the week that you roll your money over.
When a rollover is the right choice
Sometimes plan sponsors don’t do their jobs, of course, and it could be that your 401(k) plan stinks. Small-company plans are notorious for their limited options and high costs. Here’s when you should think about bolting:
All your investment options cost 1% or more. The average total expense ratio for stock funds in 401(k) plans has dropped to 0.54%, so if you’re paying a lot more than that, it may be time to move on. (You can analyze your plan’s fees with this tool, powered by FeeX.)
You can’t (or don’t want to) transfer to your new employer’s plan. If the new plan isn’t any better, it doesn’t accept transfers or just doesn’t exist — many companies don’t offer 401(k)s — then a rollover to an IRA could be a reasonable choice as long as you pick a low-cost option. That could be a discount brokerage with an array of low-fee funds, or a robo-advisor, many of which can manage your money for a total cost of 0.5% or even less. Check out “Best IRA Accounts: Top 2016 Picks.”
“Ask for a side-by-side comparison showing the all-in cost of the proposed IRA investments versus the current 401(k) costs,” says Jeanie Schwarz, a personal financial planner at NerdWallet. “A rollover may be a better option, but the consumer should get all the facts and ask for a fee comparison.”
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What a rollover can cost you
Before you pull the trigger on an IRA rollover, though, you need to understand the other disadvantages, which are numerous:
- No loans. You can’t borrow from your IRA for more than 60 days once a year without incurring taxes and penalties. If you can roll your old 401(k) into your new employer’s plan, though, you typically can take out loans and pay yourself back.
- No early access. You normally can’t tap your IRA before age 59½ without penalty, but money can be taken from 401(k)s penalty-free starting at age 55 if you leave your job.
- Less creditor protection. Your 401(k) has unlimited protection in bankruptcy court and against creditors’ claims. Your IRA’s bankruptcy exemption tops out at $1,283,025, and protection from creditors’ claims varies by state. In my state of California, for example, only amounts “necessary for support” are exempted, which could be a lot less than the balance you’ve accrued. Most people won’t get sued or butt up against these limits, but if you’re a big saver or live in California, Georgia, Maine, Mississippi, Nebraska and Wyoming — or ever wind up living there — you should understand the risks. (Those states don’t offer full protection to traditional IRAs, including rollovers. Some states don’t offer full or any protection for Roth IRAs, including Maine, Mississippi, Montana, Nebraska, West Virginia and Wyoming.)
- A huge tax trap with company stock. Roll your company stock over into an IRA, and you’re giving up a big potential tax break since withdrawals will be taxed as ordinary income. If you instead transfer your company shares to a taxable account when you leave your job, you’ll owe income tax on the stocks’ original cost, but any subsequent growth can get favorable long-term capital gains treatment. The rest of your 401(k) can be rolled into another employer’s 401(k) or to an IRA. Ask your tax pro how to take advantage of this “net unrealized appreciation,” or NUA, feature.
- A chance to put off required minimum distributions. IRA money has to start coming out of your account after you turn 70½. If you’re still working at that age, though, you don’t have to begin distributions from your current employer’s 401(k) plan until you actually retire.
You may not hear about these disadvantages if you turn to a financial services firm for advice. Three years ago the U.S. Government Accountability Office mystery-shopped financial service call centers and found one-third immediately launched into a pitch about why rollovers were the right choice.
“Within 10 to 15 seconds, you have the call center representative trying to convince the caller [to roll over a retirement account] without any knowledge about the financial situation,” Hauptman says.
You can hear some of the pitches on this video.
By the way, if you decide you’ve made a mistake with a previous IRA rollover, you may have a “do over” option. Some employer 401(k) plans accept transfers from IRAs in addition to transfers from other employer’s plans, Schwarz says.
Clock ticks toward a big change
IRA rollovers aren’t just big business for Wall Street — they’re huge business. Most of the $7.6 trillion held in IRAs comes from rollovers, according to the Investment Company Institute. The amount rolled into IRAs in 2013 was nearly 13 times the amount contributed directly, according to the Employee Benefits Research Institute, and an earlier ICI study found that more than 90% of funds going into IRAs came from rollovers. More than $400 billion a year is rolling into IRAs from company plans every year as the baby boomers begin to retire, according to research firm Cerulli Associates.
Which is why Wall Street is really nervous about the Department of Labor’s new fiduciary rule for retirement money. Starting in April 2017, advisors are supposed to start putting clients’ interests first when counseling them about retirement funds, including rollovers. Imagine a time when advisors are forced to tell people the truth about the costs and disadvantages of a rollover.
Financial services firms can imagine exactly that. Which is why they’re likely to make a full-court press for your money in coming months.
“They have a new incentive to recommend rollovers that may not be in the best interests of the client,” Hauptman says. “I would expect to see an uptick in rollovers before the rule goes into effect.”