What to do with your 401(k) or 403(b) if you leave your job

  by Jesse Anderson

A while back, I had the radio on in the car, listening to an investment show on the radio:

“Hi. My name is Ron. I am a first time caller.”

“Hi, Ron. What can I help you with?”

“I was laid off from my employer due to downsizing. I was wondering whether to leave my 401(k) where it is or roll it into an IRA?”

The host was emphatic. The caller should not leave his 401(k) with his former employer. Period.

So far so good. I completely agree. You want to roll your 401(k), 403(b) or SIMPLE over to an Individual Retirement Plan (IRA) – either Roth or Traditional – as soon as you leave your employer.

Ron said, “I’ve always heard that. Can you tell me why that is?”

Good Advice with Faulty Reasoning

The host then explained that you are in danger of losing your 401(k) if your former employer goes out of business. The radio show host gave the right answer, but then he gave the wrong reason!

Your employer – current or former – is not the custodian of your 401(k) account. The employer doesn’t hold the money – a third party does.

So the concern isn’t that you will lose your 401(k) if former employer goes bankrupt. All of your contributions and vested employer contributions are safe.

You may be thinking, but what if the bank, brokerage, or insurance company who has custody of my 401(k) money goes under?

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Rest easy. The money you have invested in your employer sponsored retirement plan, or any brokerage account for that matter, is held in completely separate sub-accounts. It cannot be co-mingled with other funds, it is shielded from creditors and the custodian can’t use your money to pay its bills or debt under any circumstances.

In the off chance your plan custodian did go under, your company, which is called the plan sponsor, will either transfer the plan to another custodian, or more likely, the custodian will be taken over and your company will become a client of that new company.

Why Should You Roll Your Money Over?

If bankruptcy isn’t the issue, why is it so important to roll your 401(k) or 403(b) to an IRA when you leave your employer?

The primary benefit of the IRA, over the 401(k), 403(b) or SIMPLE, is that you have more investment alternatives in an IRA. In a 401(k), unless you are lucky enough to have a self-directed brokerage window, you are probably limited to the mutual funds offered by your plan administrator.

In an IRA, you can buy and sell the entire universe of investment alternatives, including all stocks, bonds, mutual funds, options, real estate, and even privately held companies.

While that is the most important reason to roll your 401(k) over into an IRA when you leave, there are others.

Lower Fees

If invested properly, your fees will probably be lower in an IRA than a 401(k). Fees are very important for three reasons: 1) reducing fees is risk free return; 2) reducing fees leaves more money in your pocket to compound over time; and 3) studies show the one thing most correlated with performance, over time, is not the fund manager, the sector, the asset class or the historical performance, but low fees.

As a general rule, fees are inversely correlated to portfolio performance; the higher the fees, the worse the performance. The lower the fees, the better the performance, which is, of course, a very practical reason why you should learn to be your own money manager.

Access to Funds and Other Benefits

Another reason to move from a 401(k) to IRA, is easier access to your money, although I’m not sure this is such a good thing. If you want to rob your retirement account, you don’t have to ask for permission, nor is there any bureaucratic paperwork. You have a thousand miles of rope to hang yourself with.

There are estate planning benefits as well. While the rules have changed in recent years, allowing 401(k) plans to be stretched by your beneficiaries, it is still up to each individual plan sponsor to write that into the plan document. Some have and some haven’t.

An IRA custodian that doesn’t allow for a stretch after your death is, in my experience, rare. Finally, you can split IRAs between multiple beneficiaries and IRAs are easier to allocate when you have non-spousal heirs.

A transfer of your 401(k), 403(b) or SIMPLE to an IRA is a non-taxable event, so long as you do it properly. There should be no taxes, fees, or penalties.

The Bottom Line

While you are employed, you have to max out your employer sponsored retirement plan if you can. At a minimum, you should contribute enough to get the full employer match, if there is one. But if there is a silver lining to losing your job, being able to self-direct your retirement funds is one.

Whenever you leave an employer – either voluntarily or not – get that money rolled over to an IRA as soon as you can. Never leave your 401(k) with your old employer, and even worse, never ever roll your old 401(k) money into your new employer’s plan, when you are lucky enough to find a new job.

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