The pros and cons of an IRA rollover

Posted by on August 18, 2009 @ 11:15 am in Retirement

I recently participated in a live webcast attended by a number of Vanguard retirement plan participants. The topic was retirement investing, and questions came fast and furious. We answered as many as we could in our allotted 30 minutes.

One question we didn’t get to: What are the plusses and minuses of keeping money in a 401(k), as opposed to rolling over to an IRA? It’s unfortunate that we didn’t have time to discuss this, as it’s an important question, and the answer can vary depending on what’s going on in your life.

Leaving your job—voluntarily or otherwise—typically gives you the option of leaving your vested retirement plan contributions where they are or rolling them into an IRA. You could also cash out, but doing so means paying income tax on the withdrawal, as well as penalties if you’re under age 59½. If you’re moving on to another job, it may also be possible to roll your old 401(k) into your new one. You don’t have to make a decision immediately, but since your contributions to the old 401(k) end when your job does, you can’t take a loan from your account, and you must repay any outstanding loans in full to avoid owing taxes on the balance.

If you’ve changed jobs frequently over the years and haven’t done anything with your retirement savings, you probably have accounts spread across a number of institutions. There’s a good chance you’re getting a steady stream of mail from each institution apprising you of your account balances, changes in fund lineups, statutory notices, and so on. In situations like this, it’s easy to overlook your beneficiary designations, or even to lose track of your money. That’s one reason consolidating your assets into an IRA is so attractive—you’ll know where everything is, and you’ll find it a lot easier to keep an eye on your asset allocation.

A counterargument: Many retirement plans offer funds or services more cheaply than what you’d find by “shopping” as an individual investor. If so, you might consider leaving your plan contributions where they are. Make sure to compare expense ratios and other fees before you decide.

Still, an IRA will probably offer you a much broader choice of investments. IRAs also have a wide array of withdrawal options for you and your family. You won’t avoid income taxes, but you can avoid penalties—and you won’t have to worry about ever-changing plan rules or deal with your former employer when it’s time to access your funds.

Another potential advantage: IRAs can, subject to very specific IRS rules, be tapped penalty-free for college expenses, health insurance premiums, or the purchase of a new home. And if you’re retiring early, say at age 50, you can set up “substantially equal periodic payments” from an IRA without penalty. (If you retire at 55 or later, 401(k)s provide penalty-free withdrawals without the need to meet the SEPP requirement. This particular withdrawal benefit is not available with an IRA.)

So, I’m curious about your experience with rollovers. How have you handled the decision? How has it worked out? And is preserving your investment options more important than reducing your expenses?

Notes:

• All investments are subject to risk. Consider consulting a tax advisor concerning your individual situation.

• When taking withdrawals from an IRA or qualified plan before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.

• The link to IRS.gov will open a new browser window. Vanguard accepts no responsibility for content on third-party websites.

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