If you’re entitled to a distribution from your 401(k) plan (for example, because you’ve left your job, or you’ve reached age 59½), and it’s rollover-eligible, you may be faced with a choice. Should you take the distribution and roll the funds over to an IRA, or should you leave your money where it is?
Across the universe
In contrast to a 401(k) plan, where your investment options are limited to those selected by your employer (typically mutual funds or employer stock), the universe of IRA investments is virtually unlimited. For example, in addition to the usual IRA mainstays (stocks, bonds, mutual funds, and CDs), an IRA can invest in real estate, options, limited partnership interests, or anything else the law (and your IRA trustee/custodian) allows.*
You can move your money among the various investments offered by your IRA trustee, and divide up your balance among as many of those investments as you want. You can also freely move your IRA dollars among different IRA trustees/custodians–there’s no limit on how many direct, trustee-to-trustee IRA transfers you can do in a year. This gives you the flexibility to change trustees as often as you like if you’re dissatisfied with investment performance or customer service. It also allows you to have IRA accounts with more than one institution for added diversification.
However, while IRAs typically provide more investment choices than a 401(k) plan, there may be certain investment opportunities in your employer’s plan that you cannot replicate with an IRA. And also be sure to compare any fees and expenses.
Know the Distribution Rules
The distribution options available to you and your beneficiaries in a 401(k) plan are typically limited. And some plans require that distributions start if you’ve reached the plan’s normal retirement age (often age 65), even if you don’t yet need the funds.
With an IRA, the timing and amount of distributions is generally at your discretion. While you’ll need to start taking required minimum distributions (RMDs) from your IRA after you reach age 70½ (and your beneficiary will need to take RMDs after you die), those payments can generally be spread over your (and your beneficiary’s) lifetime. (You aren’t required to take any distributions from a Roth IRA during your lifetime, but your beneficiary must take RMDs after your death.) A rollover to an IRA may let you and your beneficiary stretch distributions out over the maximum period the law permits, letting your nest egg enjoy the benefits of tax deferral as long as possible.
The RMD rules also apply to 401(k) plans–but a special rule allows you to postpone taking distributions until you retire if you work beyond age 70½. (You also must own no more than 5% of the company.) This deferral opportunity is not available for IRAs. Note: Distributions from 401(k)s and IRAs may be subject to federal income tax, and a 10% early distribution penalty (unless an exception applies). (Special rules apply to Roth 401(k)s and Roth IRAs.)
Gimme shelter – Don’t Forget About Creditor Protection
Your 401(k) plan may offer better creditor protection than an IRA. Assets in most 401(k) plans receive virtually unlimited protection from creditors under a federal law known as ERISA. Your creditors cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you’ve declared bankruptcy. (Note: individual (solo) 401(k) plans and certain church plans are not covered by ERISA.)
In contrast, traditional and Roth IRAs are generally protected under federal law only if you declare bankruptcy. Federal law currently protects your total IRA assets up to $1,245,475 (as of April 1, 2013)–plus any amount you roll over from your 401(k) plan. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you’re concerned about asset protection, be sure to seek the assistance of a qualified professional.
Let’s stay together
Another reason to roll your 401(k) funds over to an IRA is to consolidate your retirement assets. This may make it easier for you to monitor your investments and your beneficiary designations, and to make desired changes. However, make sure you understand how Federal Deposit Insurance Corporation (FDIC) and Securities Investor Protection Corporation (SIPC) limits apply if you keep all your IRA funds in one financial institution.
Fools rush in
While some 401(k) plans provide an annuity option, most still don’t. By rolling your 401(k) assets over to an IRA annuity, you can annuitize all or part of your 401(k) dollars. Many 401(k) plans have loan provisions, but you can’t borrow from an IRA. You can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties.