AFA-Associates, Inc. Newsletter

SHOULD YOU STAY IN YOUR OLD 401(k)

OR ROLL IT OVER INTO AN IRA?

Every year millions of workers who are either retiring or changing jobs struggle with a difficult decision regarding their old employer's 401(k) or similar defined-contribution retirement plan.

They know they don't want to cash in their account because of the income taxes, potential penalties, and loss of tax-deferred growth. Yet they're unsure whether to leave their money in the old plan, roll it into a new employer's defined-contribution plan if available, or roll it over into an individual retirement account. Each option has its benefits and disadvantages, depending on their personal situation.

Advantages of staying with old employer's plan or joining new plan. Roughly one in three workers leave their money behind in old employers' 401(k) plans, according to the Employee Benefits Research Institute. Often it is because they don't want to fuss with the rollover paperwork or they're afraid of making a costly mistake. Nonetheless, staying put in the old employer's plan or rolling it into a new employer's plan does offer some advantages.

One is creditor protection. Federal law prohibits creditors from invading ERISA protected 401(k) accounts. The question as to whether an IRA is protected under State law is complex and consumers should seek expert counsel where such issues or concerns arise. Most appeals courts have now extended protection to IRA's. However, even in those States where protection is afforded, it is generally subject to some kind of "reasonable necessity" standard. To oversimplify this exceedingly complex topic; the elderly, with just enough money to scrape by in their IRA, are more likely to enjoy protection than a young, healthy person with significant assets in an IRA, who has a full career still ahead of him. Under state law, asserting "reasonable necessity" in order to claim protection for an IRA from creditors, therefore, can often involve litigation or at the very least, hefty legal fees.

If you leave work due to termination or retirement, you may begin withdrawing from a 401(k) as early as age 55 without incurring the ten-percent early withdrawal penalty. Generally, you have to wait to age 59 1/2 for penalty-free withdrawals from an IRA unless taking substantially equal period payments over your projected lifetime, or, one of the limited exceptions allowed under the Internal Revenue Code.

Two-thirds of 401(k) plans offer "stable-value" investment company shares, which are less commonly offered in IRAs. These asset classes appeal to conservative investors because they tend to offer healthier yields than money markets but with the same stable principal.

Investment choices are often more limited in a 401(k). Why might this be an advantage? Some studies show that investors who trade a lot hurt their personal returns more than those who don't trade as much. IRAs typically offer a much bigger universe of investment choices than 401(k) plans. Thus, investors tempted to trade, or those who are so overwhelmed by too many investment choices they do nothing, may actually be better off sticking with their 401(k). But the option to stay will depend in part on the quality of the investment options your particular 401(k) offers compared with an IRA. It may also depend on other factors such as overall expense ratios and whether the company owner is also acting as a plan trustee or administrator.

You may generally borrow from a 401(k) if you're working for the same employer providing the 401(k), but you cannot borrow from an IRA. Some financial planners discourage borrowing from a 401(k); the borrowed money no longer grows tax deferred and there's a risk you won't be able to repay it in time, resulting in heavy taxes and penalties. Still, it is an option that often beats borrowing from a credit card in high interest rate environments.

If you want to leave your money in your former company's 401(k), be sure it will stay there. Currently, employers can cash out defined-contribution accounts valued at $5,000 or less if the employee fails to take action. That's changing beginning on March 28, 2005, however. For accounts valued from $1,000 to $5,000 the employer must automatically roll the money into a default IRA unless the employee wants the cash or requests a rollover.

Advantages of rolling into an IRA. For prudent investors, one of the biggest attractions of IRAs is their wider universe of investment choices, particularly if the choices are superior to those available in their old or new employer's plan. And you don't have to worry about future investment options changing, as they often do in employers' plans. Workers who change jobs frequently may find themselves accumulating numerous, scattered employer retirement accounts and may risk losing track of them. Also, it's easier to manage one single IRA, than multiple employer-sponsored plan accounts. It is now possible to shift assets from an IRA to a 401(k), so in the above example, all of the consolidated assets from various plans could be shifted into a new employer plan at a later date and once the employee has settled into long term employment.

Another major benefit for the IRA option is the potential for significant tax savings. With an IRA, you can designate a younger non-spousal beneficiary and "stretch out" the minimum withdrawals over that person's lifetime. A 401(k) plan may contain provisions stating that the account be immediately cashed out if the heir is not a spouse, resulting in a much larger tax bite and loss of further tax deferral. With a rollover IRA, you may also be a position to convert to a Roth IRA if that conversation makes financial sense for you.

Whether choosing an IRA, staying with an existing plan or shifting assets to a new employer sponsored plan, working with a CFP® Certificant and seeking his expert guidance, will make the decision making process that much easier.

This article was produced by the Consumer Affairs Dept. of The Financial Planning Association and provided to you courtesy of Terry P. Welsh, CFP, Ketchikan, Alaska. If you have any questions or concerns regarding this, or any other financial topic, please call me at 1-907-225-0619, or click on the "CONTACT US" button to arrange for a free initial consultation.