How to Help Clients Decide on 401(k) Rollovers

Your clients will likely change jobs a number of times over the course of their career. One of the decisions that is critical is what to do with their 401(k) or similar defined contribution retirement plan such as a 403(b) or a 457. Typically, there are four options to consider:

• Roll it over to an IRA with an outside custodian.
• Roll it over to a new employer’s 401(k) plan.
• Leave the money invested in their old employer’s plan.
• Take a distribution.

Each of these options can have their place. Let’s take a look at each and how you might advise your clients to proceed. (For more, see: How to Pay Minimal Taxes on Retirement Assets.)

• Lower costs and more options: Depending upon the options available either in your client’s old plan or their new employer’s (if that’s an alternative), an IRA will offer a wider selection of investment options that may carry a lower cost.
• Consolidating old accounts: Rolling their old 401(k) to an IRA offers your clients the opportunity to consolidate this and other retirement accounts in one place. Especially if your relationship with this client is a new one, this can be a good way to add value to the relationship.
• The DoL fiduciary rules and rollovers to IRAs: The new fiduciary rules may put a damper in some rollovers from 401(k)s to IRAs. If this results in the client paying higher fees for the investments in the IRA, a BICE disclosure form may be required. There is some speculation that the fiduciary rules will put a damper on rollovers to IRAs.

If the client is moving to a new company with a 401(k) and if that plan allows rollovers, this can be a good option if the plan offers a solid investment menu and carries low overall costs. Many larger employers have access to ultra-low cost institutional funds and collective trusts that are cheaper than what can be had via an IRA.

If your client will be working past age 70.5, they do not have to take their required minimum distribution if they are not a 5% or greater owner of the company and their employer has elected to offer this exception. Additionally, if this employer’s plan allows it, your client can also do a reverse rollover from their IRA of any money that went in originally on a pre-tax basis. This allows the RMD on this money to be deferred until your client retires from this employer as well.

Additionally, money held in a 401(k) plan can offer great protection for creditors than an IRA in some states if this is an issue for your client. (For related reading, see: Helping Clients Avoid Retirement Landmines.)

This can be a good option if your client’s old 401(k) plan is well-run and offers a menu of low cost institutional mutual funds and other investment options. The same logic regarding the ability of some employers to negotiate very low fees and offer excellent, low-cost institutional options applies here as well if applicable to this plan. Likewise, with the creditor protection issue under this scenario as well.

If your client has a balance under $5,000, their old employer may force them to take a distribution. It is important that you provide them with advice in terms of what do with this money. Even if your client has a larger sum, their old employer might move their funds to an IRA designed especially for former employees.

If your client is younger than 59.5 and taking a distribution from their retirement plan, it will result in a 10% penalty in addition to any taxes due. There are a number of exceptions where the penalty is waived including to satisfy an IRS levy, disability, high unreimbursed medical expenses and several others.

Generally, you will want to counsel your client to avoid taking a lump-sum distribution, especially if they have a number of years to go until retirement. There are two scenarios to consider for clients in terms of withdrawals. (For related reading, see: How to Create a Retirement Investment Policy.)

• Separation from service at age 55 or over: If your client separates from service with their employer during the year in which they reach age 55 or later, distributions from their 401(k) will not be subject to the 10% penalty if they are under age 59.5. 
• Net unrealized appreciation: If your client’s 401(k) contains appreciated company stock, it may behoove them to use this technique for this stock. Instead of rolling the shares of company stock to any IRA, they can take a distribution and pay taxes on the cost basis of the shares. When they sell the shares down the road they will pay taxes at preferential capital gains rates, which can result in significant tax savings. The non-company stock portion would be rolled to an IRA to preserve the tax-deferred treatment.

Helping clients make the best decision regarding their old 401(k) plans when they leave an employer is among the most important advice that financial advisors can provide their clients. (For related reading, see: How to Choose Between a Roth or a Traditional 401(k).)