Should you keep your money in your 401(k) plan even after you leave your employer? You may have heard that it’s cheaper to move your money into an IRA, but that’s not always the case. MyBankTracker explains why you shouldn’t be so quick to move your 401(k) to an IRA, even if your new employer doesn’t offer a 401(k).
- 401(k) rules
- Creditor protection
- Penalty-free emergency withdrawals
- Professional investment monitoring
- IRA expenses are usually higher than 401(k) expenses
- In IRAs, you pay retail
- Small fee differences can make a big difference in the long run
- Watch out for distorted fee comparisons between IRAs vs. 401(k) plans
- The extra cost of 12b-1 fees
- Also watch out for claims of ‘free’ IRAs
By law, if you leave an employer and your 401(k) account has a balance of at least $5,000, you cannot be forced to take your money out of the account. You may leave it in this 401(k) for as long as the plan exists, all the way into your retirement years. You won’t be allowed to contribute more money into the account, but you will be allowed to reallocate your money into different investments available through the plan.
There are good reasons for creating a protection like this for 401(k) participants. Cost is one of the main reasons, but it’s not the only one.
First of all, by law, creditors aren’t allowed to take your 401(k) money, whether you lose a lawsuit or go into bankruptcy. Your IRA money doesn’t have the same protection.
Penalty-free emergency withdrawals
Your 401(k) plan may allow you to make hardship withdrawals without triggering the 10 percent IRS penalty. These are situations such as buying your first home, paying for major medical expenses, paying to repair damage from a severe hurricane, and others. IRAs don’t offer this opportunity.
Professional investment monitoring
Every 401(k) plan is supposed to have a financial professional or firm monitoring the performance of every investment choice available to participants. If a fund performs poorly for a few quarters in a row, it’s supposed to go on a “watch list.” If it continues to perform poorly, it’s supposed to be replaced. You don’t get this benefit with an IRA.
Now on to costs, the area of where financial companies focus the most when trying to get people to roll over their 401(k)s into IRAs.
IRA expenses are usually higher than 401(k) expenses
You may hear that an IRA costs less than in a 401(k). This is rarely the case. However, it might be true if:
– You don’t hire an advisor and pay an annual fee of 1 percent or more, plus some commissions earned when you invest in certain types of securities, like closed-end funds. You will, however, be in the DIY zone, so you will need to be financially savvy and pay attention to your investments.
– You invest your IRA money exclusively in index funds, which have the lowest expenses of any type of mutual fund. Your 401(k) might have index funds, though, too.
– You invest in individual stocks or bonds and pay a fee to buy them but don’t pay another fee until you sell them years later.
– Your 401(k) plan is at a small employer that might be getting overcharged unwittingly, with exorbitant, unnecessary fees and expenses, and overpriced mutual funds. (Larger employers will have a financial advisor on their side to negotiate reasonable fees for them.)
Apart from those situations, 401(k) plans are, apples to apples, less expensive — often much less expensive — than IRA accounts. Here’s why:
In IRAs, you pay retail
Mutual funds come in different “share classes.” For example, there are “A shares,” which are retail-priced, and “I shares,” which are institutionally priced. The A shares and I shares are exactly the same in all respects except one: cost.
In an IRA, as an individual consumer, you pay retail (you get the A shares), which are the most expensive version. In many 401(k) plans, especially plans with 500 or more employees, the mutual funds are another share class (I shares or otherwise) that are priced below retail.
According to MarketWatch, the average cost of a retail-priced stock mutual fund ranges between 1.25 percent and 1.5 percent. For retail bond mutual funds, the average is between 0.75 percent and 1.0 percent. In contrast, according to the Investment Company Institute, the average cost in 2013 of a stock fund in a 401(k) plan was 0.58 percent. For a bond fund in a 401(k) plan, it was 0.48 percent. In other words, if you move your money from the 401(k) to an IRA, your mutual funds could end up costing you an extra one-half a percent. Is that meaningful?
Small fee differences can make a big difference in the long run
Say you have $20,000 in your 401(k), you roll it over into an IRA, you invest in mutual funds that cost half a percent more than they cost in the 401(k), and you keep the money for 35 years. As the calculators below show — earning 6 percent vs. 5.5 percent (the difference caused by the extra expense) — you would end up with about $1,500 less every year for 25 years.
The annual difference is much greater if you happen to earn 7 percent vs. 7.5 percent, for example, as the calculators below show.
Watch out for distorted fee comparisons between IRAs vs. 401(k) plans
Getting people to roll over their 401(k) money into an IRA is big business, because the financial firm gets to capture a new account that isn’t starting out at $0. This translates into instant, significant revenue for the firm. The temptation can be great enough to seduce some websites to use selective, slanted data to promote IRAs as having lower fees than 401(k) plans.
Take this page on Mint, for example. The page has a retirement calculator that’s supposed to help you see how rolling over your money into an IRA will lead to your having considerably more money at retirement than if your money were left in a 401(k) plan. It appears, at first, to be objective, until you notice the links to financial companies that would be happy to help you quickly and easily roll over your money into their own IRAs.)
Mint uses assumptions for this illustration that has a hypothetical 401(k) with total expenses of 1.2 percent and a hypothetical IRA that is a third of the expense (0.4 percent). Mint can make any assumption it wishes, as long as it’s disclosed, as it is here — but they’re misleading. It is highly unlikely that your IRA will cost so little. In fact, as the discussion above about paying retail vs. institutional prices illustrates, the IRA is likely to cost more than the 401(k).
The extra cost of 12b-1 fees
Retail mutual funds in IRAs typically have a “12b-1” fee. This is essentially a fee charged by the fund company to recoup marketing expenses. (The industry calls it a “distribution” expense, because fund companies pay for other financial firms to distribute their funds. It’s industry jargon for marketing.)
Typically, the financial advisor is the recipient of this fee. In many 401(k) plans, especially those at companies with roughly 500 or more employees, the mutual funds don’t have this fee, or if they do, the advisor typically rebates it back.
Also watch out for claims of ‘free’ IRAs
If you see promotions for free or no-fee IRAs, don’t believe them. There is no such thing. A free or no-fee IRA isn’t a reason to move your money out of the 401(k). It’s a reason to stay away from that the company promoting it.
In fact, the Financial Industry Regulatory Authority, called FINRA, has warned firms to stop promoting their IRAs as no-fee/free. If an advisor or salesperson truly believes an IRA is free, find a new person to guide you.
If you do want to move your money, anyway, here are options for how you should rollover your 401(k).
Marc is a freelance writer for MyBankTracker.com who specializes in investing and retirement planning. He is an expert in asset allocation and portfolio management.