Advanced Personal Finance

There has been lots written about what to do with a 401(k) when you leave a job and why.  I’m not going to rewrite those posts.  Instead, what I do want to talk about is my experience rolling a 401(k) over into an IRA.  I’ll show you how to do it and pitfalls to avoid.

When you leave an employer in whose 401(k) plan you participated, you have some decisions to make regarding your retirement savings.  Really, your options are three:

• Leave the money in your old employer’s plan
• Roll your account into the new employer’s plan (if allowed)
• Rollover into an IRA

I recently left my job and chose the third option - a 401(k) to IRA rollover.  It had been many years since I did this last and I’d forgotten how it goes, so I thought I’d review it here.

Step 1: Decide where to open the IRA

There are several advantages to rolling a 401(k) into an IRA.  Two of the biggest are investment options expand dramatically (for good or bad) in an IRA and the opportunity to save money on fees.

401(k)s are inherently limiting.  You’re limited in what you can invest in (that is, only what your employer offers).  You also can’t take your business elsewhere if a 401(k) plan gouges you on fees.  A rollover to an IRA gives you an opportunity to fix these problems.

When evaluating where to open your rollover IRA, you want to look at those two elements - investments offered and fees charged.  In this case, bigger is better.  You want to go with a large fund family or brokerage.  Vanguard, Fidelity, and T. Rowe Price come immediately to mind.  Generally, they charge very low fees on their products.  They also give you lots of different investment options from which to choose.

But I didn’t use any of these three.  I used USAA because they are my all-purpose financial provider.  I’ve written before about their awesome service and I like having all my accounts consolidated in one place.

Step 2: Contact your choice and set up accounts, if necessary

After I decided to go with USAA for my rollover, I gave them a call.  I already had retirement accounts of various types open with them.  I wanted to prepare the ground for the rollover, though.  I called USAA and had them open two new accounts - a Roth rollover account (since some of my 401(k) is the Roth type) and a money market account for the traditional IRA.  Why money market?  I want to rebalance everything once it’s consolidated, so this gives me the opportunity to do that.

Step 3: Call the administrator for your old plan

I then called the administrator of my old employer’s plan - Fidelity.  They were excellent.  They actually have a group of people assigned to assist people after they’ve left my old company.  Naturally, they’re there to also try to get you to leave the money with Fidelity, but I did not get a hard sell.

I have a bit of a complicated situation in that I have traditional 401(k) contributions, Roth 401(k) contributions and after tax contributions.

There’s a big difference between an IRA rollover and a 401(k) rollover.  In an IRA to IRA rollover, you never see the money.  It goes electronically from one investment firm to another.  Not so with a 401(k) rollover.  In that case, the checks have to be sent to you (”For the benefit of [the investment firm]” is written on the checks) and you send them to the investment firm.

I think this is a stupid set-up for a couple of reasons.  First, seeing a (hopefully) large dollar figure on a check makes people question rolling it over.  I think it might encourage 401(k) withdrawals.  Secondly, there’s a (admittedly small) chance the checks might be lost in transit or be deposited incorrectly.  Finally, if you’re not careful and forget about it, you might take a withdrawal inadvertently.

Anyway, I recently got the checks in the mail and now have to close the loop and send the checks to USAA.  At that point, the 401(k) to IRA rollover will be complete.  Then it’s time for a complete review of my asset allocation.

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This was a new one to me.  I learned another weird IRS rule today.  This one was about 401(k) rollovers and after-tax contributions.

A couple of months ago, I changed jobs.  Today I called the my old employer’s 401(k) plan administrator, Fidelity.  The man assigned to help me with the disposition of my 401(k) was very helpful, especially with my somewhat complicated situation.

My now-former employer allowed Roth 401(k) contributions beginning last year and I took advantage of the opportunity.  (Incidentally, I highly recommend taking advantage of the Roth 401(k) if you’re offered it.)  Several years ago, I screwed up at the end of the year and didn’t shut off my 401(k) contribution in time.  I hit the limit for that year but money kept coming out of my paycheck and was contributed after tax.

So I had three sources of funds for the rollover: 

• Traditional before-tax
• After-tax Roth
• After-tax non-Roth. 

So this wasn’t a straightforward rollover.  The guy helping me actually had to get help from another guy who knew the rules a little better.

Here’s where the weird IRS rule comes in.  If your (joint) AGI is below $100,000, you can have the after-tax non-Roth funds rolled over as a current year Roth IRA contribution.

Our income this year is slightly over that amount, so the rule is I can’t have a check made out to USAA (the place I’m having the money from Fidelity sent to) directly as a 2008 Roth IRA contribution.  What I have to do is have the check made out to me and then send it to USAA.

In fact, I could do whatever I want with the money since I’ve already paid taxes on it, but using it toward this year’s Roth IRA sounded like a good idea.  Trouble is I can’t do that in one easy step. 

Like I said, weird rule.

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For many people (me included), maxing out both a 401(k) (or 403b) and Roth IRA isn’t feasible. (Ok - for us, it’s feasible, we’ve just chosen to go a different way with our money.) Everyone must make the same decision with their money - how to allocate it. You could max out a Roth IRA, but maybe you’d rather eat out often. That’s a perfectly valid decision assuming you’ve actually made the decision consciously.

So if, like many people, you’ve decided maxing a 401(k) and Roth IRA is an either/or proposition, you have a big decision to make.

Is it better to save in a 401(k) or a Roth IRA?

Here is a head-to-head comparison of the 401(k) and Roth IRA. Assuming you’re eligible for both, this guide should help guide you to the right retirement savings account for you.

• Investment Options

Many 401(k) plans offer an inappropriate number and type of investment choices. Plans can have either too many or too few choices. Too many can cause investor paralysis or a ‘little bit of everything’ allocation. Too few choices can cause a dangerous overweighting in one asset class and other problems. Another problem with 401(k) plans can be the investment options themselves. Funds that are expensive in terms of load and/or management fees directly and dramatically affect your account balance at retirement.

On the other hand, a Roth IRA can be invested in almost anything. You can invest in Exchange Traded Funds (ETFs) with their low-fee advantage. You can choose mutual funds, fixed income assets (e.g. bonds), Real Estate Investment Trusts (a kind of real estate ‘mutual fund’), or most anything else. Being able to invest in whatever you want obviously is a great advantage because you’re not limited to your company’s investment choices.

Advantage: Roth IRA

• Access to Funds

You might need access to your savings prior to retirement for any number of reasons. While it’s almost never advisable to withdraw money you’ve saved for retirement before actually reaching retirement, circumstances sometimes dictate that course of action. For example, an extended job loss may require you to dip into retirement savings.

Most 401(k) plans offer an option to borrow some of what you’ve contributed. If you take this route, you pay the money back just like any other loan. Effectively, the loan payment comes right out of your paycheck and goes back into the 401(k) account.

The main thing to note about 401(k) loans is that, with most plans, you must pay any remaining balance in full immediately upon leaving your place of employment. If you can’t, the loan becomes a distribution with all the major disadvantages that come with those.

You can get money out of a Roth IRA in an emergency, too. There are two major differences with a Roth, though. First, the money you take out is not a loan. You can’t put the money back into your IRA once you take it out. That’s a major downer because you’re forgoing all the compounding that money would have had until retirement.

Second, you can always withdraw your initial contribution penalty-free. In other words, you can get at the money you put into the Roth IRA any time, but cannot get at the gain on that investment without penalty. So if you invested $1,000 and the account balance is now $1,500, at most you can withdraw the $1,000 without penalty.

Advantage: Depends. If you are confident you’ll be able to repay the money and will remain employed until you do, a loan from a 401(k) is the way to go. If the money won’t likely be repaid (e.g. a house down payment), use the Roth IRA.

• Creditor Shielding

The 401(k) is protected from creditors under federal law. You can be forced to surrender part in a divorce, but not in the event of a judgment or bankruptcy.

The Roth IRA, on the other hand, is at the whim of state law. As such, it’s possible a creditor could attach your Roth IRA depending on the state you live in.

Advantage: 401(k)

• Matching Contribution

Some 401(k) plans include a employer match. Typically, for some percentage, your employer will match your contributions. If your plan offers a match, not contributing up to this maximum is leaving free money on the table. There are times, however, when it may make sense to forgo an employer match and save outside the 401(k).

Naturally, the Roth IRA offers no matching contribution. You’re on your own with a Roth.

Advantage: 401(k)

When weighing whether to invest in a 401(k) or a Roth IRA, give these four points some thought. The answer won’t be the same for everyone, but thinking it through will help get you to a nice comfy retirement.

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IRS rules dictate that some tax credits and deductions have income limits. Make too much money, and it’s no tax credit for you. Here are the major tax credits and deduction with their associated income limits. Where appropriate, numbers reflect the point at which phase-out begins. All numbers are for 2006. I’ll update after 2007 numbers are published.

Child tax credit ($1,000 credit per dependent child)

• Married filing jointly: $110,000
• Married filing singly: $55,000
• All others: $70,000

Lifetime learning credit (up to $2,000 credit per tax return)

• Married filing jointly: $90,000
• All others: $45,000

Hope scholarship credit (up to $1,650 credit per student)

• Married filing jointly: $90,000
• All others: $45,000

Student loan interest deduction (up to $2,500 deduction)

• Married filing jointly: $100,000
• All others: $50,000

Traditional IRA (deduction up to yearly maximum contribution - currently $4,000)

• Married filing jointly: $75,000
• Single: $50,000

Roth IRA (informational only - no deduction or credit)

• Married filing jointly: $156,000; cannot contribute to Roth IRA if over this amount
• Single: $ 99,000
• Married filing single: Cannot contribute to Roth IRA

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Here’s a topic I’m sure to never face - inheriting an IRA. But for those people who might find it of some use, here’s a run-down on how to inherit an IRA.

Step 1: Have a relative wealthy enough to leave money to you.
Step 2: Help that relative set up an IRA naming you as beneficiary.
Step 3: Wait until relative dies.
Step 4: Decide what to do with inherited IRA.

Inherited IRAs really fall into two categories - spousal and non-spousal. Non-spouses can take all the cash out of the IRA immediately, establish a beneficiary IRA and begin taking annual distributions, or wait up to five years and then take the lump sum. Spouses have the additional option of making the IRA their own.

Cash-out option. Any beneficiary can use the cash-out option. This simply involves taking a lump sum and paying the tax on it as ordinary income.

Establish a beneficiary IRA. Going this route means taking annual distributions. The IRS publishes tables with life expectancy based on sex and age. Your annual distribution is based on how much longer the IRS says you’ll live. Since the IRS is always right, these tables come in handy for all sorts of things. I myself base my borrowing decisions on them. I try to arrange repayment beginning the year after the IRS says I’ll die. At any time, you can also take a lump sum.

Deferral cash-out. You can also do nothing for up to five years, then take the lump sum.

Roll-over option (spouses only). Spouses have the additional option of rolling over the IRA into one with their name. This also allows them to continue making contributions. Using this option, the spouse doesn’t have to begin distributions right away. Deferring taxes is nearly always preferable to paying them right now, so this is most likely the smartest move for the surviving spouse.

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