401(k) plans are an excellent tool for building retirement savings, and we strongly encourage their use to maximize their potential. Employer contributions are essentially free money, and the higher contribution limits offered through 401k plans make them one of the best tax-advantaged retirement plans available. Employers sponsor these plans to help you build retirement savings, and they have proven to be an effective tool used to support retirement for over 30 years. When you change jobs or retire, however, it often makes good sense to roll your account over to your new employer’s 401k or to your own IRA. Employers would prefer that because it simplifies their responsibilities; after all, keeping track of former employees, providing disclosures, and managing documentation long after you’ve moved on can be burdensome for them. But more importantly, rolling over funds allows you to gain greater control of your money.
When you leave your employer or retire, your 401(k) account becomes frozen, meaning you can no longer contribute to it. You can’t take out any loans. Of course, it will sit and grow based on your investment performance, net of fees, but you really don’t control the account. For example, your ex-employer can change the plan, change the menu of investment options available to you and renegotiate the services and fees at any time. A 401k is not a contract between you and the recordkeeper or custodian; it’s between the employer (or plan sponsor) and the recordkeeper. Your employer serves as a fiduciary for all plan participants and beneficiaries, including terminated or retired employees. However, when the ties are severed with your employer, it may be better to move your funds into your own retirement account (IRA) or roll them into your new employer’s plan, if applicable. There are many reasons why that could be beneficial but the most important reason is so you can track and monitor your investments more closely. For those not yet retired, forgotten or neglected investments accounts don’t tend to grow at optimal levels. Even small accounts can be very valuable for your future. For example, if you are 30 years old with a $25,000 401k balance, consider that it could grow to over $400,000 by the time you are age 65 (based on 8-10% annual return), but if you don’t ensure your investments are properly allocated with changing market conditions, you could have substantially less.
As you approach retirement, it becomes increasingly important to manage your investments with a focus on your evolving needs. Retirement is a significant milestone that often calls for a different approach compared to the accumulation phase. Unlike the growth-focused strategy of earlier years, retirement requires strategies that emphasize capital preservation, income generation, and flexibility. While 401(k) plan investment options may be adequate for building wealth, they often fall short in preserving capital and generating steady income. The default investment menus provided by many 401(k) plans typically lack the dynamics and flexibility needed to construct an all-weather portfolio tailored for retirement. Traditional stock funds generally do not offer the stable income and consistent growth required, and generic fixed income funds often fail to meet these critical needs.
401(k) plans are undoubtedly a powerful tool for building retirement savings. However, when you leave your employer or retire, it's crucial not to let these funds sit idle without a thoughtful evaluation of your options. Too often, individuals put off making the rollover decision and end up neglecting these accounts, missing opportunities for greater flexibility, control, and the ability to keep their funds working as hard as possible. An indecision is a decision, so now is the time to decide on whether to stay or go. To help with that decision, it's essential to understand the relevant rules and carefully weigh the pros and cons of each option, as some decisions can be irrevocable; therefore, this article will explore the strategic considerations for managing your 401(k) rollover, guiding you through the steps to ensure your retirement funds are optimized to support your long-term financial goals.
The True Cost of 401(k) Fees
One of the most critical, yet often overlooked, aspects of 401(k) accounts is the fees. While 401(k) plans are a convenient way to save for retirement, they are not free. Fees can include administrative costs, investment management fees, and individual service fees. Over time, these fees can add up and significantly impact your retirement savings. However, the key consideration isn’t just about the fees themselves but about the value you’re receiving in return.
Would you rather pay administrative fees for a 401k plan that offers no financial planning or investment support or receive personalized financial planning and investment management? While the fees may be different, the real value lies in what you gain. Administrative fees in 401(k)s often cover recordkeeping and other plan administrative and maintenance costs but do not provide tailored advice or guidance. In contrast, working with a fiduciary, such as with an IRA rollover, ensures that your investments align with your goals, risk tolerance, and income needs in retirement.
Rolling over your 401(k) into an IRA or another professionally managed account allows you to maximize the value of the fees you’re paying, turning fees into an investment in your financial success rather than a cost of convenience. For example, if you have $500,000 in your 401(k) and are paying a .50% annual fee, that’s $2,500 per year. Over 20 years, assuming a 6% return on investments, fees could cost you tens of thousands of dollars. That may be the cost of accessing the 401k, but how does the fee for your old plan compare to that of your current 401k, if applicable, or to alternative IRA fees?
Some 401(k) participants are unaware of the fees they’re paying because they’re often buried in plan documents. The fees are not limited to the investment fund expenses. Some smaller plans may “hide” the fees within one bundled fund expense, but whether they are transparent or hidden, rolling over your 401(k) into an IRA or a new employer’s plan that provides either lower fees or improved services can potentially save thousands of dollars or improve your investment returns over the long term. At the very least, consolidation allows for a more mindful investment approach.
Why You Should Keep Your 401(k) Close
Let me share a quick story to illustrate why keeping your 401(k) close to your hip is so important. A client of mine, Sarah, once came to me after switching jobs multiple times in her career. She had four different 401(k) accounts scattered across various employers, all with different investment options and fee structures. Sarah admitted she hadn’t reviewed some of these accounts in years, and when we dug into the details, we found high administrative fees in one account. Another account had been moved to a new provider by her former employer, resulting in a blackout period where she couldn’t access her funds for several weeks. And two other plans had investment allocations that were underperforming substantially. It all added up to lost control and missed opportunities.
When Sarah decided to roll all her old 401(k)s into a single IRA with our professional management, it was like hitting the reset button on her retirement planning. She now has a consolidated account, a comprehensive investment strategy, and greater control over her funds. More importantly, she gained peace of mind knowing her money was being actively managed to align with her retirement goals.
When you change jobs, it’s generally recommended to keep your 401(k) close by rolling it into your new employer’s plan or an IRA. Keeping your funds consolidated helps you maintain better control over your investments and reduces the complexity of managing multiple accounts. A centralized approach can also help you align your investments more effectively with your retirement goals and risk tolerance. That said, it’s important to understand that these accounts are tax-qualified, which means you need to know the rules—especially when it comes to Roth 401(k)s.
Got Roth? Know the Rules!
For those with a Roth 401(k), understanding the five-year holding rule is essential. It’s also important to understand Roth IRAs rules since you will likely find yourself rolling over funds to a Roth IRA some day. While both Roth 401(k)s and Roth IRAs offer tax-free growth and withdrawals, the five-year rule works very differently between the two. It can impact when and how your funds are accessed, especially if you want to secure the benefit of tax-free earnings.
The Five Year Holding Rule
The five-year holding rule is a safeguard to ensure that the tax advantages of Roth accounts are reserved for long-term retirement savings. Essentially, it requires that a Roth account remains open for a minimum of five years before earnings can be withdrawn tax-free. This rule applies not only to earnings on contributions but also to any funds converted from traditional accounts, discouraging the use of these funds for short-term gains. The underlying purpose is to promote a long-term investment mindset, ensuring that taxpayers benefit from the tax-free growth intended for retirement planning.
The rules for a Roth 401k and a Roth IRA are different, however, and they apply to the account individually. Let’s address these differences so you can ensure that you are able to use these funds with the most tax-advantages.
Roth 401(k): With a Roth 401k, the five-year holding period applies to the account itself, starting from the year of your first contribution. For example, if you made your first contribution in 2020, the five year holding rule started 1/1/2020. Suppose you contribute to a 401k with XYZ company, making Roth contributions in 2020. Technically, you can access the earnings tax-free starting in 2025 (subject to age 59 1/2 rule and your plan rules for distributions). Suppose you change jobs in 2023 and start contributing to ABC Inc. Now, your 5-year clock will start on January 1st the year of your first contribution to that account, which in this example, would be 1/1/2023. Those earnings would not be available tax-free until 2028.
There is a workaround, however. When you roll over funds from one Roth 401(k) to another Roth 401(k), the five-year holding period from the original account carries over to the new plan. This means that the start date, 1/1/2020 in this example, applies to the new ABC Inc Roth 401(k), helping you meet the requirements for qualified tax-free distributions sooner. If you do this, it's important to ensure that the new plan's administrator accurately records this information. The IRS states that the plan administrator of the distributing plan is required to provide the receiving plan with a statement indicating the first year of the five-year period and the portion of the distribution attributable to basis. This ensures that the receiving plan can properly track the holding period. If ever challenged, though, it will be up to you to provide evidence that you have satisfied the five-year holding rule.
Roth IRA: With a Roth IRA, the five-year holding period applies to the account itself, starting from the year of your first contribution, similar to the Roth 401(k). Just as in the example above, the IRA must have been open for at least five years to receive tax-free withdrawals (subject to the age 59 1/2 rule). However, this holding period does not extend from the 401k to the IRA. A Roth 401k rollover to Roth IRA is not considered a “like for like” account so the original start date with your Roth 401k does not carry over to the Roth IRA.
The workaround here is to roll over your Roth 401(k) into an established Roth IRA. In fact, if you have made Roth 401(k) contributions and have not yet set up a Roth IRA, it might be a good idea to do so now. Even a small contribution, if eligible, will start the five-year clock immediately and help preserve your tax-free benefits without restarting the clock if you roll over your funds at retirement or in the future. Also, keep in mind that you can roll over an existing Roth IRA to a different custodian (such as from Fidelity to Schwab) without resetting the clock. The original contribution date will carry forward, but just as with 401k rollovers, you should keep your records in case you need to provide supporting documentation if challenged by the IRS.
This rule applies to each account separately so if you open a new Roth IRA each year with your yearly contributions, each account will have its own 5-year clock. And, as already noted above, if you roll over a Roth 401(k) into a new Roth IRA, even if you satisfied the five-year holding rule within your 401(k), the clock will start over again with the new Roth IRA.
The Age 59 ½ Rule
While the age 59 ½ rule seems straightforward - in order to access your earnings tax- and penalty-free, the account must be at least 5 years old, and you much be at least age 59½, there are differences between the Roth 401k Age 59 ½ Rule and the Roth IRA Age 59 ½ Rule.
For Roth 401(k) distributions, the age 59½ rule applies to both your contributions and earnings. Although Roth 401(k) contributions are made with after-tax dollars, meaning the contributions themselves are not taxed upon withdrawal, when you take distributions from a 401k, you cannot specify whether you want to withdraw only your after-tax contributions or your earnings. Consequently, if you take a distribution before age 59½, even if the account is 5 years old, you will likely face both taxes and a 10% early withdrawal penalty on the earnings portion of the distribution. This is because Roth 401(k) distributions are considered pro-rated, meaning both your contributions and earnings are withdrawn together. Therefore, while your after-tax contributions aren't taxed again, any early withdrawal will proportionally include earnings, which may be subject to penalties and taxes if it’s a non-qualified distribution.
As an example, let’s suppose you have $35,000 in a Roth 401k with a former employer. You contributed $25,000 and have $10,000 in earnings. You decide you want to take out your $25,000 after-tax contribution. As you see it, you paid taxes on those dollars so the age 59 ½ rule and 5- year rule doesn’t apply – or so you think. Unfortunately, that is not true with the Roth 401k. If you take out $25,000 such as in this example, a prorated portion will be deemed contributions and earnings. Earnings make up approximately 28.6% of the account ($10,000 ÷ $35,000); therefore, if you withdraw $25,000, roughly $7,143 will be considered earnings, subject to the 10% penalty tax. Earnings will also be subject to state and federal taxes if the 5-year holding period has not been met.
Roth IRA distributions follow a similar 59½ rule as Roth 401(k) accounts, but with an important distinction: the age requirement applies only to earnings. With a Roth IRA, you can withdraw your contributions—the after-tax dollars—at any time without taxes or penalties, thanks to IRS ordering rules that prioritize contributions over earnings. For example, if an employee rolls over the above Roth 401(k) into a Roth IRA, the $25,000 contributed amount can be accessed tax-free and penalty-free even if the individual is under age 59½, provided that it consists solely of contributions.
However, to withdraw any earnings tax-free, the Roth IRA must have been open for at least five years and the account holder must be at least 59½ years old. This added flexibility makes Roth IRAs more accessible for early withdrawals of after-tax contributions compared to Roth 401(k)s.
The age 59 ½ and five-year rule for a Roth IRA applies only to the earnings. You can withdraw your contributions at any time without tax or penalty, regardless of how long the account has been open.
What About Roth 401(k) Distributions Over Age 59 ½? They May Not Be Tax-Free!
At age 59 1/2, qualified distributions from your Roth 401(k) become available without the 10% early withdrawal penalty, but whether distributions are income tax-free is only provided the account has met the five-year holding period. This means both your after-tax contributions and earnings can be withdrawn tax-free if you are age 59 1/2 and you have held the account for at least 5 years. If the five-year requirement hasn’t been satisfied, only your contributions are tax-free, while earnings may still be subject to taxes. Again, as noted above, since you cannot specify which dollars you wish to withdraw from a 401k, it is important to understand that even though you are over age 59 ½, you may still find Roth distributions subject to taxes. Additionally, as an employer-sponsored plan, Roth 401(k) distributions might be influenced by specific plan rules that can affect how and when you access your funds.
For Roth IRAs, turning 59 1/2 allows you to withdraw funds without penalties, but remember there is a key distinction: your after-tax contributions are always accessible tax-free, while tax-free access to earnings requires that the account has been open for at least five years. However, once both conditions are met, you can withdraw both contributions and earnings without incurring taxes or penalties. The ability to distinguish contributions versus earnings provides Roth IRA holders with enhanced flexibility compared to employer-sponsored Roth 401(k)s, making it easier to manage your funds both before and during retirement.
Understanding these nuances is crucial when rolling over a Roth 401(k) into a Roth IRA to ensure compliance with the five-year rule and avoid unintended taxes or penalties.
Required Minimum Distributions (RMDs):
Both Roth 401(k)s and Roth IRAs are exempt from RMDs during the account holder’s lifetime. Your funds can continue to grow tax-free without mandatory withdrawals, offering enhanced flexibility in retirement planning.
The Limited Investment Menu of 401(k)s
A downside of 401(k) plans is their limited investment menu. Most 401(k) plans offer a curated list of mutual funds, target-date funds, and sometimes a few other options. While this simplicity can be helpful for novice investors, it often falls short for those who desire greater control or access to specialized investment strategies.
Additionally, 401(k) plans are predominantly growth-focused and often lack a robust portfolio of lower-risk, fixed-income investments. They typically offer only one cash-equivalent or money market fund option, which may come with market value adjustments that can result in either a cost or a gain, depending on prevailing interest rate conditions at the time of redemption, introducing uncertainty to what is otherwise intended as a safe haven for funds. Even if the investment fund options appear to be performing well in current market conditions, the limited selection raises concerns about whether they offer the flexibility needed to effectively navigate challenging market environments, particularly during retirement when preserving income is critical.
Moreover, there are typically no hedging strategies available or diverse, dynamic options for accessing non-stock or bond markets. This limited selection can make it challenging for retirees to prioritize income stability and preservation over aggressive growth. Plan sponsors also have a fiduciary duty to periodically review the investment options within the plan, meaning they may remove or replace funds they deem unsuitable, leaving you with no control over these changes. As a plan participant, you are subject to these decisions, which can significantly impact your investment strategy.
When you roll your 401(k) into an IRA, you gain access to a broad array of investment options, including individual stocks, bonds, ETFs, real estate, and alternative investments. This expanded menu enables you to tailor your portfolio to your specific needs, risk tolerance, and retirement goals, providing greater flexibility and the opportunity to build a more comprehensive investment strategy. However, it's important to note that different investment strategies may come with higher costs, so you should carefully evaluate your overall plan before making any changes.
Professional Management: Why It Matters
Managing retirement savings is complex, especially as you approach or enter retirement when the stakes are higher and the margin for error is smaller. In many 401(k) plans, you’re responsible for handling your own investment decisions and errors in managing taxes, withdrawals, or allocations can lead to costly consequences. Additionally, as previously mentioned, 401(k) plans typically offer a limited investment menu that is heavily growth-focused, often lacking robust lower-risk or hedging options that are essential for preserving capital during volatile market conditions.
Professional management can significantly enhance your retirement strategy by providing expert guidance tailored to your long-term financial objectives. Financial advisors help optimize your portfolio, minimize taxes, generate sustainable income, and navigate market volatility, reducing the likelihood of mistakes and missed opportunities. Moreover, rolling your 401(k) into an IRA opens up a broader range of investment options, such as individual stocks, bonds, ETFs, real estate, and alternative investments, while granting you access to personalized advice and greater flexibility to build a diversified portfolio aligned with your specific needs, risk tolerance, and retirement goals.
Generating Income in Retirement
For retirees, one of the biggest challenges is converting a 401(k) balance into a reliable income stream. Most 401(k) plans are not designed to provide the flexibility and tax-efficient strategies required in retirement. Generating income is not just about setting up systematic withdrawals or exploring annuity options—it’s about ensuring your withdrawals are tax-efficient, maintaining flexibility, and having easy access to funds when needed.
By rolling over your 401(k) into an IRA, you gain more control over your income strategy. An IRA allows you to:
- Implement tax-efficient withdrawal strategies, such as managing required minimum distributions (RMDs) and coordinating withdrawals with other income sources to minimize your tax burden.
- Maintain flexibility, ensuring you can adapt your withdrawals to unexpected expenses or market conditions.
- Enjoy ease of access to a wider range of investments, enabling you to balance growth and income more effectively.
A well-structured IRA, guided by professional management, can help you build a customized income plan that supports your lifestyle while preserving your retirement savings for the long term.
By rolling over your 401(k) into an IRA, you can work with a financial advisor to develop a customized income strategy. This might include creating a diversified portfolio that balances growth and income, setting up a systematic withdrawal plan, or exploring annuity options that provide guaranteed income.
Hiring the Right Advisory Team
When selecting a financial advisor to guide you in retirement planning, it’s essential to prioritize those who operate as fiduciaries, meaning they are legally required to act in your best interest at all times. A fiduciary advisor will provide objective advice, putting your needs first rather than recommending products or services based on commissions or conflicts of interest. Additionally, choosing an advisor who specializes in retirement planning ensures they have the expertise to create a strategy tailored to your financial goals, navigate complex retirement regulations, and help you manage risks that are unique to retirement. The right advisor can be a key partner in ensuring your retirement plan is sustainable and aligned with your vision for the future.
I believe hiring the right advisor is crucial for effective retirement planning. Of course, given that I have helped thousands navigate the complexities of retirement for over 30 years, I’ll admit that I am biased. However, the world of investment options, financial strategies, taxes, longevity risk and technology is growing faster and more significant with each passing decade. It’s easy to become overwhelmed and paralyzed by the options, miss out on opportunities or make costly mistakes. I’ve seen it many times over in my career. That said, I do believe everyone transitioning into retirement should look for a qualified fiduciary financial advisor who specializes in retirement planning and who is committed to acting in your best interest.
Not only will a qualified advisor help you navigate the complexities of managing your retirement accounts, but a strong team will tailor your investment strategy to your long-term goals, and provide guidance through market volatility, help you craft a custom holistic retirement and financial plan and help you with other important decisions such as health care choices, tax considerations, risk management strategies and more. With the right team supporting you, you gain peace of mind knowing that your retirement strategy is being managed professionally and aligned with your unique financial objectives.
Key Considerations When Rolling Over Your 401(k)
Of course you need to consider your individual situation, including your financial resources, goals, investment preferences, and overall retirement strategy, before making any decisions. Understanding your unique needs and options ensures that the decisions you make with your retirement savings, be it to rollover or leave with an ex-employer, aligns with your long-term financial objectives and regulatory requirements.
- Fees: Compare the fees of your current 401(k) plan, your new employer’s plan, and an IRA to determine the most cost-effective option.
- Tax Implications: Ensure rollovers are handled correctly to avoid triggering taxes or penalties.
- Investment Options: Consider whether the expanded menu of an IRA would benefit your retirement strategy.
- Income Planning: Evaluate how well your current plan supports income generation versus the flexibility of an IRA.
The Bottom Line
Rolling over your 401(k) when you change jobs or retire is not just about simplifying your finances; it’s about taking control of your financial future. From reducing fees and accessing more investment options to customizing tax strategies and creating a sustainable income strategy, the benefits are clear.
I often say leaving your money with an ex-employer is like leaving it with an ex-partner or ex-spouse—it’s a relationship you’ve moved on from, and it’s time to take your money and move forward. While it might be easy to leave it as is and put off any major decisions to a “better” time, procrastination can cost missed opportunities. By rolling over your 401(k) into an IRA or another account under your control, you ensure that your hard-earned savings are working for you and aligned with your current and future financial goals.
At the end of the day, your retirement savings represent decades of hard work and dedication. Treating all accounts with the care and attention they deserve can make all the difference in achieving a comfortable and secure retirement. If you’re facing a decision about your 401(k), consider consulting a financial advisor to ensure you make the best choice for your unique circumstances.
The information provided in this blog is believed to be accurate but cannot be guaranteed. This content is for informational purposes only and should not be construed as investment, tax, or legal advice. It is not intended to serve as a substitute for consulting with a registered investment advisor, financial planner, or tax professional who can consider your individual circumstances. Investing in retirement accounts—including 401(k) rollovers—carries risks, including the potential loss of principal.