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Tuesday, February 13, 2007

401K: why roll over one 401K to another?

When you leave one company for another, one important choice is what to do with your old 401K. Should you roll it over into a some sort of IRA (either Traditional or Roth) or should you roll it into your new employer's 401K?

Personally, I've always rolled old 401Ks into IRAs, and never understood why anyone would roll an old 401K into a new 401K. As far as I can tell, the only reasons to roll an old 401K into a new 401K (versus into an IRA) are the following:

1. Laziness - you only want one retirement fund. But at a minimum, you should have a 401K and a Roth IRA.
2. Many 401Ks have loan features, which aren't available in IRAs.
3. The 401K has superior investment options that aren't available in the open market.
4. You want to avoid trading fees.

Point 1 is acceptable, but should be recognized as laziness, and not a truly valid "reason".

Point 2 is OK, but dangerous - 401K loans are a good way to get yourself into trouble.

Point 3 is valid, but extremely rare. Pretty much all employer 401K plans invest in publicly available mutual funds; if you like the fund, you can find out its symbol and invest in it directly in your IRA if you so prefer.

Point 4 is probably the most valid, but this can also be avoided by parking your IRA at Vanguard or some other good mutual fund company, where you can invest and trade in the company's funds for free.

The reasons for rolling a 401K into a traditional IRA include the following:

1. You can invest in any stock, mutual fund, or any other investment available in the market. In an employer 401K, you're limited to the portfolio they make available.

2. You can Roth-ize the rollover when convenient.

3. Your rollover money is not encumbered by your employer's financial issues. This actually became an issue for me once: I didn't bother to roll over an old 401K, and my old employer croaked and went Chapter 7. My 401K was held up in the bankruptcy court for awhile. I got it all out, but it was scary.

#3 is not that rare. Many large companies have institutional funds at lower expenses that are not available to retail investors. Some plans have funds that are closed to retail investors. Some plans have Vanguard funds which you can invest in without having to meet the Vanguard minimum investment requirement.

Outside of those cases, it's usually best to rollover to an IRA. Most people end up paying more AND having worse funds in a 401k.
I'll admit that I don't have much experience with big-company 401Ks since I've been a startup addict for most of my career.

You are right about small company 401K investment options. Thankfully, my current company has a S&P 500 index fund, but other than that, they've all been awful.

I think part of the problem is big companies like Vanguard won't touch your 401K until you have at least $1M in the company's aggregate 401K account; this rules out small startups. Instead, you get managed funds with big fees that are used to subsidize the account.

In one company, I just put all my money into the MM fund - and it managed to be the best performer from the period 1997-2000. Losing money in the stock market during that time took some serious "skill", but somehow all the funds in that plan managed to do so...
#2- Although still dangerous, I believe a form of loan from a Traditional/Rollover IRA is still possible. I'd have to double-check, but I believe withdrawls can be repaid within 60 days without penalty. I may be thinking of 401k withdrawls though, and I do NOT recommend it in any case.
One problem with rolling a 401k into an IRA is that an IRA does not provide protection from legal judgements. In other words, creditors can take your IRA, but not your 401k.

So if for some reason your life goes tits-up, like an expensive medical emergency, you can rest knowing that you can go bankrupt without loosing your 401k.

I have most of my retirement tied up in an ex-employeers 401k, and refuse to roll it to an IRA for this reason.

Note: Texas and Florida provide the same protection to an IRA as an 401k. California does not. In California, creditors can take as much as a judge allows them to.
Judgments are one issue in favor of keeping the 401K. On the flip side, T-IRAs have somewhat better inheritance properties than 401Ks, although the inheritance properties suck for both.

For my part, I figure the chance of a judgment that exceeds my umbrella liability insurance is far smaller than the investment risk of bad investment options - typical of 401K plans in smaller companies - or the loss of the ability to Roth-ize if/when I want to.

But if your 401K has good investment choices, this works for you. At the end of the day, it's all about what lets you sleep at night...
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