When you leave — or lose — a job, you typically face a decision with your 401(k) money: leave it in the company plan or roll it over into an IRA. There are several advantages in choosing the rollover option, especially if you already have a new employer's 401(k) for your payroll contributions, or if you retire.
A 401(k) limits you to the investing options offered by the plan, which is often a dozen or fewer mutual funds. Traditional IRAs allow you to choose from a range of investments, such as common stocks and the full spectrum of open-end mutual funds. IRAs in brokerage accounts allow you to add in bonds, exchange-traded funds and closed-end funds. Most also provide traditional bank products, such as CDs and savings accounts for your cash. In addition, IRA rules allow you to invest in such things as real estate, private partnerships, limited liability companies, and commodities, including precious metals, natural resources and agricultural products.
Most 401(k) plans place restrictions on your withdrawals, including all-or-nothing rules. These can limit your ability to create a regular income stream when you retire. More important to persons under 59 1/2, 401(k) plans have fewer hardship exceptions to the 10-percent early withdrawal penalty. For example, you can use IRA assets penalty-free for health insurance premiums when you are unemployed, for post-secondary education expenses, and up to $10,000 for the first-time purchase of a home. IRS rules allow 401(k) withdrawals for those needs, but you'll still pay a 10-percent penalty to your tax bill on the distribution. IRS rules limit such emergency distributions from a 401(k) to the amount you have paid into the plan. Rolling your 401(k) funds into an IRA permits you to also include money from investment growth and matching company contributions in hardship withdrawals.
If you have money in 401(k) plans from more than one employer, or if you're ready to retire, consolidating all of your assets into a single IRA makes it easier to monitor your account, measure your withdrawals, and stick to your asset allocation plan.
With traditional IRAs, you calculate your required minimum distributions, which begin the year you reach 70 1/2, on the total amount in all your IRAs, but you can take the money from any account or combination of accounts. If you leave money in a 401(k) plan, your must figure that required distribution separately and take the money specifically from that account.
Many 401(k) plans require beneficiaries to withdraw all assets immediately when the account owner dies. IRA rules also require distributions to begin upon your death, but your beneficiaries are better able to spread those payments over their lifetimes. Rolling over an inherited 401(k) into an IRA can create difficulties for your beneficiaries, even for your spouse. Conversely, it's relatively easy for spouses to transfer inherited IRAs into their own IRA account.
There are times when leaving your retirement money in a 401(k) makes sense, such as when you're not sure how soon you might find your next job. Employer-sponsored plans carry protection under federal law from creditors and damage judgments. Without federal backing, IRAs aren't similarly sheltered in many states. In addition, if you retire or lose your job between ages 55 and 59 1/2, you can make penalty-free early withdrawals from a 401(k), but not from an IRA.
When you decide to roll over your 401(k) into an IRA, keep the rollover separate from other IRA assets and don't add any contributions to the rollover account until you fully retire. That will keep open the possibility of a reverse rollover — transferring the money into a new employer's plan, which allows you the option of benefitting from 401(k) advantages.