What is the difference between a 401k rollover vs IRA?

Question

I have a Fidelity account for my older company's 401k plan which will expire soon. They told me if I don't do anything, it will convert into an IRA automatically. Alternatively I can make a rollover into my current 401k plan.

What would be the difference financially? Any fees, penalties, etc? I'm thinking not to do anything so it will become an IRA automatically.

Answer 1

1. Rollovers from 401k to other 401ks or IRA are generally tax free and there are no penalties
2. There can be some paperwork involved and some banks make it more complicated than others. The bank wants to keep your money and keep collecting fees from you.
3. The best choice of where to put it depends on the investment options available. Many 401k plans have poor options that are primarily designed to optimize fee revenue for the plan administrator, not returns for you.
4. You want to invest in very low-fee index funds or ETFs. If your current 401k isn't offering this, don't roll it into that.
5. The easiest would probably be to open an IRA with a low-cost service provider, roll it into that, invest in 3-4 very broad low fee ETFs (electronically traded funds) and then leave it alone. One example of such a provider would be Vanguard (no endorsement intended).

It's really important to minimize fees. This is the single largest lever that you have as an individual investor and the long term impact on your return is profound.

Answer 2

I'm thinking not to do anything so it will become an IRA automatically.

If you decide that you don't want to move the funds to your new 401(k) because of the fees, or the poor investment choices, or your new company doesn't allow you to roll funds into the 401(k), don't just let it automatically convert to an IRA.

The automatic conversion, while quick, does mean that the old 401(k) company decides which financial company the money will be rolled into. In all likelihood it will be their financial company. They will automatically create the account, give you the information you need to establish the login credentials, and then money will be invested into whatever default investment option they pick. They should tell you in advance how they will map your existing investments.

The result could be a financial company without few good investment options, and a default investment that don't match your goals. It could be a age-based fund, or an S&P 500 fund, or something else. That means that post-transition you will still have choices to make, and you might still be rolling the funds into another financial institution.

So take the time before the deadline to pick a IRA custodian that has the options you want with reasonable expenses. Then contact the old 401(k) company and the new IRA company and get the funds rolled over.

A few notes regarding taxes:

• If the color of the money doesn't change there is no tax impact. So pre-tax funds in the 401(k) go to a traditional IRA. Roth 401(k) money goes to a Roth IRA. Company match money is also pre-tax so it ends up in the traditional IRA.
• These rollovers do not count against and annual contribution limits, because they are already retirement funds.
• If you roll the funds over to the IRA company you pick, or to the new 401(k), do not have them write the check to you. Get the new company to tell you what words need to be on the check, if the funds can't be transferred electronically, and then have the old company follow the instructions. Getting the check made out to you adds paperwork and deadlines, and could have tax complications.

Answer 3

Another difference that hasn't been mentioned is in the case where you might want to do a "backdoor Roth IRA contribution" in the future. A "backdoor Roth IRA contribution" is a non-deductible contribution to Traditional IRA followed by a conversion to Roth IRA. If there are no pre-tax funds in Traditional/SIMPLE/SEP IRAs, these steps accomplish the same result as a regular Roth IRA contribution (you get the money into a Roth IRA without needing to pay taxes in the process), except that it has no income limit (whereas a direct contribution to Roth IRA has an income limit).

However, if you rollover funds from your Traditional 401(k) to Traditional IRA, it will cause there to be pre-tax funds, and it will interfere with backdoor Roth IRA contributions. The reason is that conversions or distributions from Traditional IRA are subject to the "pro-rata rule" which takes out both pre-tax and post-tax amounts in the same proportion as in all your Traditional/SIMPLE/SEP IRAs overall. The post-tax funds from the non-deductible Traditional IRA contribution will mix with the pre-tax funds from your rollover, and any conversion will consist of part pre-tax and part post-tax funds, rather than all post-tax funds. The IRA aggregation rule aggregates the funds in all accounts, so putting it in a separate account will not help.

On the other hand, if the funds stay in 401(k) (i.e. by rolling it over to your current company's 401(k)), this will not happen.