Many people, after retirement, hope to transfer the funds in their 401(k) retirement account to an Individual Retirement Account (IRA). This is because, according to the regulations of the Internal Revenue Service (IRS) in the United States, if the funds from a retirement account are directly transferred to another retirement plan account, such as an IRA, this transfer typically isn’t subject to withholding taxes.
You might think that this move can save money and is a convenient solution, but there are some important points to consider. Some individuals may overlook the costs associated with transferring funds from a 401(k) to an IRA.
According to data from the financial services company Employee Fiduciary, 401(k) plans and IRAs may offer different share classes for mutual funds: 401(k) plans typically provide Institutional Shares, while IRAs mostly offer Retail Shares.
These two types of share classes have different costs, with Retail Shares offered by IRAs typically being more expensive.
Institutional Shares usually require investors to contribute a higher initial amount, with the minimum investment often exceeding $100,000. To meet this threshold, employer-sponsored retirement plans concentrate employees’ contributions for investment. Additionally, Institutional Shares generally have lower expense ratios.
Once you transfer funds to an IRA, you typically can only purchase Retail Shares, which have lower minimum investment requirements, allowing even individuals with lower 401(k) balances to invest easily. However, due to the lower threshold, the costs of these shares are usually higher than Institutional Shares.
However, there is an exception where the costs of Institutional Shares may be higher than Retail Shares. According to Employee Fiduciary, so-called “revenue sharing” involves embedding administrative and record-keeping expenses into the operating costs of mutual funds and then paying a portion of these fees to the service provider of the retirement plan.
It is crucial to understand whether your 401(k) funds operate under a revenue sharing mechanism or directly incur related costs. Directly incurred fees must be clearly itemized in the 408(b)(2) and 404(a)(5) fee disclosure documents, retirement plan financial statements, and your account statements.
For revenue sharing fees, they may be presented as estimates in the 408(b)(2) fee disclosure document or included in the fund expense ratio listed in the 404(a)(5) disclosure document. These fees may not appear on the financial statements of the retirement plan or on participants’ account statements.
Therefore, if you are considering transferring your 401(k) to an IRA, you should take into account how the retirement plan collects and pays fees.
When contemplating a 401(k) rollover to an IRA, it is essential to compare the expense ratios of the funds in your current retirement plan and the anticipated funds to be invested in after transferring to the IRA.
According to Davies Wealth Management’s recommendations, you should review the fund fact sheets of various funds, which clearly outline the expense ratios of the funds. As mentioned earlier, if your employer’s retirement plan offers low-cost Institutional pricing for index funds, this advantage may disappear once you transfer funds to an IRA.
Moreover, mishandling the rollover of retirement funds can lead to tax consequences. One critical aspect is understanding the difference between a “direct rollover” and an “indirect rollover.”
Under IRS regulations, in an indirect rollover, if your former employer sends you a check directly, they must withhold 20% for federal income tax.
In a direct rollover, also known as a trustee-to-trustee transfer, the funds move directly from the 401(k) to the IRA without passing through your hands.
Many early retirees are impacted by the “Rule of 55.”
According to IRS regulations, if you leave a company at or after the age of 55 (or 50 for public safety workers), you can take penalty-free withdrawals from your employer’s 401(k) plan. While you still need to pay 20% in taxes, you will not be subject to the 10% early distribution penalty.
However, if you roll over your 401(k) to an IRA, you lose the ability to utilize the Rule of 55 to avoid the early withdrawal penalty. Generally, the Rule of 55 applies to qualifying employer retirement plans and not IRAs. Once funds are transferred to an IRA, unless under other exceptions, you typically have to wait until age 59 and a half to withdraw funds without facing the 10% early withdrawal penalty.
Nevertheless, there are some exceptions to the early withdrawal tax, as defined by the IRS.
According to Davies Wealth Management, the 1974 Employee Retirement Income Security Act (ERISA) provides unlimited creditor protection for assets held in a 401(k) plan or any other employer-sponsored retirement plan.
The protection afforded to IRAs is not entirely the same as what ERISA offers. The specifics may depend on the state you reside in and the type of legal claims creditors bring against you.
One potential increased cost after moving a 401(k) to an IRA is financial advisor fees.
Investors often begin working with financial advisors at this stage, and these advisors typically have three different fee structures.
The first is Assets Under Management (AUM) fees.
Under the AUM fee model, financial advisors charge based on the total value of your investment portfolio.
According to data from the independent financial advisory company Afton Advisors, most financial advisors charge annual fees ranging from 0.25% to 2% of the investment portfolio’s value. For example, if your investment portfolio is worth $500,000, and the financial advisor charges 1%, you would pay $5,000 annually.
This fee information can be found on your account statements.
The second way of compensating financial advisors is through commissions. Accounts operating under commission-based compensation function differently, as financial advisors earn income through commissions generated by trades in mutual funds or other investment products.
The third and most preferred method of advisor compensation is the flat fee structure. Financial advisors under this structure charge a fixed amount for their services, regardless of the size of the investment portfolio or sales commissions of investment products. This fee structure is transparent, straightforward, and predictable.
While transferring a 401(k) to an IRA may be a good choice for retirees, it is not a decision to be made lightly. It comes with hidden costs, such as forfeiting the benefits of Institutional Shares. Additionally, there are additional fees involved, and creditor protection may be limited.