Ready For Retirement
Ready For Retirement
What Should You Do With Your 401k When You Retire?
Your 401(k) is likely your largest retirement asset—so the decisions made about it can have a lasting impact. This episode explores the pros and cons of keeping a 401(k) versus rolling it over to an IRA.
Learn when it makes sense to stay in a 401(k), especially for those retiring between ages 55 and 59½, when a special IRS rule allows penalty-free withdrawals not available in IRAs. Keeping pre-tax funds in a 401(k) may also support more efficient backdoor Roth strategies.
Six key factors influence the decision: cost, control, investment options, account consolidation, ease of use, and coordination across accounts. The discussion also dives into advanced strategies—such as in-plan Roth conversions, the tax treatment of after-tax contributions, and Net Unrealized Appreciation (NUA) for company stock.
The right choice depends on individual retirement timelines, tax strategies, and long-term financial goals. This episode helps uncover what to consider before making a final decision.
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The strategies, case studies, and examples discussed may not be suitable for everyone. They are hypothetical and for illustrative and educational purposes only. They do not reflect actual client results and are not guarantees of future performance. All investments involve risk, including the potential loss of principal.
Comments reflect the views of individual users and do not necessarily represent the views of Root Financial. They are not verified, may not be accurate, and should not be considered testimonials or endorsements
Participation in the Retirement Planning Academy or Early Retirement Academy does not create an advisory relationship with Root Financial. These programs are educational in nature and are not a substitute for personalized financial advice. Advisory services are offered only under a written agreement with Root Financial.
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Think you already know what to do with your 401k when you retire. You might want to think again, because the wrong decision with this could potentially cost you many thousands of dollars over the course of your lifetime. Now here's the thing with 401ks. I'm a financial advisor, and me and other advisors I work with over just the past few weeks have talked to many different clients about what to do with their 401ks, and there was not one single answer that fit appropriately for everyone. There's many different potential things you can do, and so what I'm going to do today is explain the various factors involved, various considerations, and explain which one might be most relevant given your situation, so you can make the right decision for you. The reason this is so important is that for most retirees, their 401k is going to be their largest retirement asset, so if you don't get this decision right, the impact of that could cost you dearly. So let's walk through the different factors that you need to consider when deciding what to do with your 401k. To start, let's talk about when you should not roll over your 401k, because typically, your options are going to be do you keep your money in your 401k or do you roll over to an IRA. There's some other things that you can do, but those are the two main options. Here's why you wouldn't want to move money out of your 401k. Number one, if you're retiring but you're not yet age 59 and a half, but you are over the age of 55. If you have a 401k with a company that you are working at in the year in which you turn 55, you actually have different rules for when you can access that money penalty free. If you have an IRA, you can't touch that money until age 59 and a half, with very few exceptions. But with a 401k, that rule is actually turned to 55 if you're working at the company that you have that 401k through when you retire. So, for example, you're 56 years old, you want to retire, you have all of your money in that company's 401k. You think that you can't touch money until you're 59 and a half, but that's only if you were to take those 401k assets and roll them to an IRA. Because you are already age 55 or above and because you're currently working at that company, you could retire from that company and pull money from that 401k without the 10% penalty. You still owe taxes, but you remove the 10% early withdrawal penalty. So this option can provide you a lot more flexibility for those of you who are not yet age 59 and a half but want to retire in your 55 or older with the company that the 401k is through.
Speaker 1:Why do I say that? Well, if you're 55 and you have your 401k with this company but you have a previous employer who you also have an old 401k through, you can't touch that 401k until you're 59 and a half. The 401k through you can't touch that 401k until you're 59 and a half. The 401k has to be with the company that you are working with upon the year in which you attain age 55. So here's a potential planning strategy If you're with that company, you can always roll over previous 401ks into your current company's 401k and that way, when you do retire, much more of it becomes available to you. But just keep that in mind. The company that you have your 401k through. The age at which you can access those funds is 55, not age 59 and a half, like it is for traditional IRAs. So that could be one very good reason not to roll over your 401k into an IRA.
Speaker 1:The second good reason not to roll over your 401k is if you're doing backdoor Roth contributions. So the way backdoor Roth contributions work is technically, you're making an IRA contribution that's non-deductible and you're converting that non-deductible contribution into your Roth IRA. When you do this and I've done videos that explain this in more detail but when you do this, the IRS has what's called an aggregation rule, where it's looking at all the different IRAs. You have to determine how much of that conversion is taxable. So when you do this and I'll keep this short because, like I said, if other videos that explain this in more depth you don't want any pre-tax IRA assets. This includes simple IRAs and SEP IRAs. Instead, if you keep those funds in your 401k, they're not included in the aggregation rule. So if you are doing a backdoor Roth contribution, this is a very important detail, probably the most important one that trips people up the most. I would explore this in more detail. Talk to your CPA, talk to your financial advisor, before actually doing this. If you're not doing backdoor Roth contributions, this is not as relevant. Let's now talk about other considerations that you should be looking at when it comes to deciding do you keep your money in a 401k or do you roll it over to a traditional IRA.
Speaker 1:Number one is cost. Now, thankfully, things have gotten a lot better in the last several years. It used to be very common to see 401ks with a whole bunch of hidden fees. You wouldn't think you're paying anything because you don't necessarily see anything on your statement, but when you start to unpack the cost of the funds that you're invested in or the cost of the plan, you could see fees as high as two, two and a half percent sometimes. Thankfully, that seems to be coming down because there are better, lower cost options, especially if you're with a larger company. Typically, you're going to have a lower cost plan it's not universal, but that tends to be the case but there can be some hidden fees in 401k. That's not to say there are not also fees in IRA, even hidden fees in IRA. What it it does mean, though, is you do need to explore the difference. What is the all-in cost of the 401k that you're in? What is the all-in cost of the IRA that you might transfer the funds to? If you're going to have an IRA that's self-directed, typically you're going to be able to do so at a lower cost at least a lower cost potential than you would in a 401k, but understand the cost of each and understand what's best for you.
Speaker 1:The second consideration is control. Generally speaking, in an IRA, it's going to be a lot easier to trade. It's going to be a lot easier to make monthly transfers or distributions on demand. It's going to be a lot easier to implement conversions, which is a strategy that a lot of people do in retirement. So if you're keeping your money in a 401k, that's perfectly fine. Maybe there's some good reasons to do so. But just understand, is flexibility, is control, is ease of use important to you? Typically, an IRA is going to be a lot better for that, and this is not a universal statement, but just on average. You're gonna have a bit more control If you need to make the one-off distributions or take monthly distributions, if you need to make the trade, if you need to do the conversion, if you want to do that in a timely manner. Iras typically have a lot more flexibility, a lot more of an ability for you to do those types of things.
Speaker 1:The next factor to consider is investment options. Usually, with a 401k, you're going to have some limited set of investment options. These options might be fantastic or they might be pretty crummy options. It's going to depend upon the plan, but in general, your options are going to be far more limited than they would be in an IRA. Now, that's not always a bad thing. Sometimes 401ks pick very strong options. What this could potentially do is prevent people from unknowingly purchasing a really bad fund or something that's really inappropriate for them, specifically a high risk fund, something that's very speculative. 401ks don't typically offer those types of options. So if you want a limited fund lineup because you know it's going to prevent you from picking something that might not be the best for you, you can make the case that 401ks are great for that are great for that. But if you want unlimited fund options, if you really want to build the portfolio that's perfect for you and what you need you're probably not going to get that through a 401k. With few exceptions, with limited exceptions, you're going to be better off in an IRA in terms of having more fund options to choose from to build the portfolio that's right for you. So understand who you are as an investor. Do you want the more limited options to prevent you, maybe, from picking really bad options, but it might also prevent you from picking the best options for you. Some people might want that, but for others, if you want unlimited flexibility to say how do you build the right portfolio for you? The IRA in general is probably going to be the better bet.
Speaker 1:The fourth factor to consider is just organization and consolidation. It's very common to meet people who have five, six, seven old 401ks and what you start to realize is it just becomes kind of cumbersome. It's a bit of a hassle to actually understand what do I have? What's it worth? What is it invested in All these various accounts? Ideally, you should be keeping those accounts organized. You could do that in a 401k, meaning anytime you change jobs, roll over your previous company's 401k into your new one. Now, like we've gone through before, you want to understand what are the costs where the investment options, what's the flexibility, what's the experience like. But that's not a bad option if all those things are good to keep your funds organized. Or do that in an IRA Every time you leave an old job, take your 401k, roll it over to an IRA, which just stands for individual retirement account, meaning you have far more control over it and you do the same thing there. But either way, you want to make sure that you're staying organized so you don't end up with half dozen dozen different accounts that you're not really tracking or managing appropriately.
Speaker 1:The fifth factor is ease of use. I already kind of touched upon this, but, generally speaking, the right IRA provider is going to give you a whole lot easier experience, better user experience, because it's not a group plan, because there's not all these different third-party administrators or record keepers or other parties you might need to go through. An IRA is streamlined, it's clean, it's easy, the accessibility is there, the tools are there. It just tends to be an easier process Not always the case, but that's often the case. So understand what's the ease of use with whatever 401k you have, with whatever IRA option also exists out there.
Speaker 1:Then the sixth factor to consider is just coordination between different accounts. If you have a robust financial plan, chances are good you have a strategic asset allocation and asset location across all your different accounts, meaning you have the high level. Here's the investment mix I want to have and you go a step beyond that to say, of this investment mix, of this asset allocation, where do I want to hold each of the different types of investment classes or asset classes? It makes sense to hold some of these in my brokerage account versus others in my traditional IRA, versus others in my Roth IRA. If you have a 401k. It's a bit more difficult to coordinate that when you have different platform, different logins to view everything, versus if you have everything in one place, which tends to be the case. If you have an IRA or Roth IRAs or brokerage accounts, you can hold all of those at the same institution. It's easier to see what is the overall mix and how is everything distributed between the various types of accounts. So those are six factors to consider and now I want to go into some specific planning points that may be incredibly impactful for many of you.
Speaker 1:The first is understand the different tax treatment of different types of 401k contributions. It's not uncommon to say you have one 401k statement. There might be a million bucks in that. That's not all treated equally. Some of that was your own contribution, some of that was an employer contribution. Some of that was your own contribution. Some of that was an employer contribution, some of that was a pre-tax contribution, some was a Roth contribution, some was an after-tax contribution, some was growth on the after-tax contribution and even though it's one balance, it's not all going to roll over to the same place if and when you move that to an IRA. So here's how that works.
Speaker 1:Any pre-tax contributions that you make, those roll over to a traditional IRA if you want to do so in a tax-free way. Any matching contributions that your employer made those also roll over to a pre-tax IRA. Now here's the catch Even if you are making Roth contributions, any matching contributions that your employer made those will roll over to a traditional IRA. Those are pre-tax contributions at the company level, which means they're going to be pre-tax on the way out and they're going to go into a traditional IRA, not a Roth IRA. Now, any Roth contributions that you made and, by the way, one of the beautiful things about Roth 401ks is it doesn't matter what your income is. There's no income limits you can make Roth 401k contributions and those contribution limits are much higher. So anything that you contributed to the Roth 401k and any growth on those Roth 401k contributions, that all rolls over to a Roth IRA if you're going to move that out of your 401k balance.
Speaker 1:Here's a tricky piece. A lot of 401ks offer what are called after-tax contributions. If you make an after-tax contribution, you're not getting a deduction on that contribution. So any dollars that you contribute to that, that dollar, that contributed amount, rolls over to a Roth IRA when you contribute to that, that dollar, that contributed amount, rolls over to a Roth IRA when you move from that company or when you do that rollover. But and this is a very important catch any growth on those after-tax contributions, that's all considered pre-tax and that would all roll over to your pre-tax IRA. Here's why that's so important.
Speaker 1:If you have after-tax contributions that you're making and if your plan allows for in-plan conversions, what you want to do is convert those assets to your Roth 401k. It doesn't cost you anything in taxes, assuming you do it immediately. So, for example, I make a $10,000 after-tax contribution to my 401k, I don't get a deduction. That's why that $10,000 could move to my Roth IRA when I roll it over. But if I keep it in the after-tax balance, any growth on that is pre-tax Pre-tax, meaning when I do pull it out it will be taxable. But if, instead, I make that $10,000 contribution, I then convert it to my Roth 401k, there's no taxes on that conversion because I didn't get a deduction when I made the contribution. Therefore it's not taxable. When I convert it, I've already paid my taxes. The difference is now any future growth on that balance is going to be tax-free because it's happening in my Roth. It's not happening in the after-tax balance. So that single decision could be something that saves you thousands and thousands and tens of thousands of dollars over the course of your retirement. Because let's assume I make that $10,000 contribution and I let this thing ride for a long time and it grows to $30,000. If I had not converted it, that $20,000 of growth is now all taxable to me when I do ultimately take it out and start spending it. Versus I simply done that conversion, that $20,000 would be completely tax-free. So very important thing to note when it comes to distributing funds from your 401k into your IRA and the things that you can do in the meantime to make sure that you're optimizing the taxation of those contributions.
Speaker 1:Another very important detail for people that have 401ks and have company stock in their 401k is you need to consider net unrealized appreciation as a potential strategy here. So net unrealized appreciation you'll see it abbreviated as NUA. What that means is you are eligible for preferential tax treatment on any of the gains that you've realized on the purchase of that company stock. For example, let's assume that you've put in $50,000 to your 401k specifically towards your company stock and your company's done tremendously well, so that $50,000 is now worth $500,000. Well, if you were to roll that all over to an IRA, that $500,000, once you start pulling it out is completely taxable, and it's taxable at ordinary income rates. Ordinary income rates are the higher rates that you're going to pay.
Speaker 1:What net unrealized appreciation would allow you to do is, it would say, take that $500,000 that's in your company stock, and there's some details here. So work with your financial advisor, work with your accountant to make sure that you're doing this the right way. But that $50,000, when you take it out, might be subject, or would be subject, to ordinary income taxes, but the gains on that, the $450,000 of gains, that would be subject to capital gains treatment. Now there are some planning strategies here, because that tax hit is immediate, whereas you're rolling over a 401k or rolling over a balance that can be deferred, that can be spread out over time. But make sure that you do the analysis to see if that would be a good strategy for you, because that can potentially be worth tens of thousands of dollars or more, depending upon how much you have in company stock and depending upon your tax bracket.
Speaker 1:And then the final thing to note here, just reiterating what we talked about before is if you have an IRA, there's going to be a 10% early distribution penalty anytime you take funds before age 59 and a half. Time you take funds before age 59 and a half, there's a couple of exceptions first time home buyer, if there's a disability, medical things like that but in general, 10% early distribution penalty if you take funds before 59 and a half. With the 401k, that age drops to 55. You have to have worked at the company that is holding the 401k up until the year in which you turn 55. But if you do so, that's a four and a half year difference in terms of how long you need to wait to avoid that early distribution penalty.
Speaker 1:So when should you use a 401k? When should you use an IRA? Generally speaking, if you have a 401k with low cost, great investment options, you might need access to the funds before age 59 and a half. You don't need a tremendous amount of flexibility in terms of trading, conversions etc. 401k might be the best option for you. If that's not the case, if you don't have great investment options, if the cost is quite high, if you do want more flexibility or ease of use or control and you don't need those funds before 59 and a half. Generally speaking, it might be best to consider an IRA for situations like that, so there's pros and cons to both. Understanding what's most relevant to you is the most important thing to determining whether you should use the 401k or the IRA as you approach your retirement. Once again, I'm James Canole, founder of Root Financial, and if you're interested in seeing how we help our clients at Root Financial get the most out of life with their money, be sure to visit us at wwwrootfinancialpartnerscom.
