One of the great things about studying for (and passing!) the CFP exam has been the exposure to a wide range of interesting minutia about various financial planning topics. I’ve learned more about the ins and outs of insurance, estate planning, and taxation than I ever thought I would.
One of the interesting tidbits I want to talk about today are some of the potential downsides to rolling over your 401k to an IRA.
ERISA
Before we jump into the specifics of 401ks, we need to talk about ERISA. ERISA (Employee Retirement Income Security Act of 1974) is a federal law that sets minimum standards for most private pension/retirement plans. ERISA was largely in response to some high-profile pension bankruptcies, such as the Studebaker pension plan failure in 1963. When Studebaker went bankrupt it was discovered that Studebaker’s pension plan it was tragically underfunded. In fact, it was so poorly funded that the vast majority of employees received anywhere from just 15% to 0% of their promised benefits.
At that time there was virtually no regulation of pension programs. Pension programs were largely intermingled with the employer’s funds. If your employer become insolvent (as with Studebaker) you’d not only lose your job, but all of your retirement benefits.
ERISA created rules requiring minimum funding for pension programs, it put in place the PBGC (Pension Benefit Guarantee Corporation), and added creditor/bankruptcy protection for individual retirement plans.
Bankruptcy protection
Here’s the interesting thing – qualified plans (like your 401k) have UNLIMITED bankruptcy protection. No matter how much money you have in your 401k, it can’t be taken by creditors. There are only 2 occasions when money can be taken from your 401k without your approval:
- To pay the IRS
- As part of a divorce settlement/court order
In short – the money in your 401k is pretty safe.
IRAs are not nearly as secure.
Prior to 2005 a regular IRA had no bankruptcy protection. The Bankruptcy Reform Act of 2005 provides a regular IRA with $1,283,025 of bankruptcy protection (this amount was initially set at $1M and is updated for inflation every 3 years).
For most people this is a distinction without a difference. After all, in 2016 the average 401k balance was a mere $92,500. The average IRA account balance for pre-retirees was $100k. These averages are well below the threshold of bankruptcy protection for either type of account.
Of course, that’s not the whole story. We would assume that the average balance grows as a participant ages, so it’s likely that the average older employee could be closer to the limit than a younger employee.
Let’s check the numbers.
Here’s a breakdown of average 401k balance by age:
And here’s a breakdown of the average IRA balance by age:
Although it’s true that older people have larger retirement accounts, it turns out that the average person with the average account balance is well protected by either an IRA or 401k, even at the older (and wealthier) end of the spectrum.
But if you’re reading this blog you, by definition, aren’t average (at least not financially). You’re somebody who is trying to gain control over your finances. There’s a good chance that at retirement you’ll have significantly more than $1.3M in today’s dollars.
To test this I ran some conservative projections for 401k and IRAs accounts to see if the cap on protection for an IRA would be an issue for the average above-average person.
Note: all of the calculations below are in today’s dollars. The yearly contribution limits for 401k and IRA accounts are adjusted annually for inflation, which means they will always be the same in 2017 dollars.
401k projection
Let’s assume a person doesn’t start saving until 25 years old, and then starts saving just $5,000/year. He increases his savings by $1,000/year for the next 13 years until he finally hits the max of $18,000/year at 38. He contributes $18,000/year until he turns 50, when he’s eligible for an additional $6,000/year “catch up” contribution.
We’ll assume a reasonable 8%/year return. Finally, we will assume no employer match. Any sort of match would obviously increase the numbers below.
Here’s what we get:
| Age | 401k | Total |
| 25 | $5,000.00 | $5,000.00 |
| 26 | $6,000.00 | $11,400.00 |
| 27 | $7,000.00 | $19,312.00 |
| 28 | $8,000.00 | $28,856.96 |
| 29 | $9,000.00 | $40,165.52 |
| 30 | $10,000.00 | $53,378.76 |
| 31 | $11,000.00 | $68,649.06 |
| 32 | $12,000.00 | $86,140.98 |
| 33 | $13,000.00 | $106,032.26 |
| 34 | $14,000.00 | $128,514.84 |
| 35 | $15,000.00 | $153,796.03 |
| 36 | $16,000.00 | $182,099.71 |
| 37 | $17,000.00 | $213,667.69 |
| 38 | $18,000.00 | $248,761.11 |
| 39 | $18,000.00 | $286,661.99 |
| 40 | $18,000.00 | $327,594.95 |
| 41 | $18,000.00 | $371,802.55 |
| 42 | $18,000.00 | $419,546.75 |
| 43 | $18,000.00 | $471,110.49 |
| 44 | $18,000.00 | $526,799.33 |
| 45 | $18,000.00 | $586,943.28 |
| 46 | $18,000.00 | $651,898.74 |
| 47 | $18,000.00 | $722,050.64 |
| 48 | $18,000.00 | $797,814.69 |
| 49 | $18,000.00 | $879,639.87 |
| 50 | $24,000.00 | $974,011.06 |
| 51 | $24,000.00 | $1,075,931.94 |
| 52 | $24,000.00 | $1,186,006.50 |
| 53 | $24,000.00 | $1,304,887.02 |
| 54 | $24,000.00 | $1,433,277.98 |
| 55 | $24,000.00 | $1,571,940.22 |
| 56 | $24,000.00 | $1,721,695.43 |
| 57 | $24,000.00 | $1,883,431.07 |
| 58 | $24,000.00 | $2,058,105.56 |
| 59 | $24,000.00 | $2,246,754.00 |
| 60 | $24,000.00 | $2,450,494.32 |
| 61 | $24,000.00 | $2,670,533.87 |
| 62 | $24,000.00 | $2,908,176.57 |
| 63 | $24,000.00 | $3,164,830.70 |
| 64 | $24,000.00 | $3,442,017.16 |
| 65 | $24,000.00 | $3,741,378.53 |
| 66 | $24,000.00 | $4,064,689.81 |
| 67 | $24,000.00 | $4,413,867.00 |
| 68 | $24,000.00 | $4,790,979.36 |
| 69 | $24,000.00 | $5,198,261.70 |
| 70 | $24,000.00 | $5,638,127.64 |
By the time this person hits “normal” retirement age of 65 he has over $3.7M in his 401k. At 70 he has $5.6M. That’s well in excess of the IRA protection limit of $1,283,025. In fact, the limit of IRA protection is exceeded when this person is just 53 years old.
IRA projection
Exceeding the IRA limit is a bit tougher, as the max contribution is only $5,500 plus an additional $1,000 catch up contribution starting at 50. Here’s what the value of an IRA would be, assuming it was opened at age 25, funded to the maximum level every year, and enjoyed an 8% annual return:
| Age | IRA | Total |
| 25 | $5,500.00 | $5,500.00 |
| 26 | $5,500.00 | $11,440.00 |
| 27 | $5,500.00 | $17,855.20 |
| 28 | $5,500.00 | $24,783.62 |
| 29 | $5,500.00 | $32,266.31 |
| 30 | $5,500.00 | $40,347.61 |
| 31 | $5,500.00 | $49,075.42 |
| 32 | $5,500.00 | $58,501.45 |
| 33 | $5,500.00 | $68,681.57 |
| 34 | $5,500.00 | $79,676.09 |
| 35 | $5,500.00 | $91,550.18 |
| 36 | $5,500.00 | $104,374.20 |
| 37 | $5,500.00 | $118,224.13 |
| 38 | $5,500.00 | $133,182.06 |
| 39 | $5,500.00 | $149,336.63 |
| 40 | $5,500.00 | $166,783.56 |
| 41 | $5,500.00 | $185,626.24 |
| 42 | $5,500.00 | $205,976.34 |
| 43 | $5,500.00 | $227,954.45 |
| 44 | $5,500.00 | $251,690.80 |
| 45 | $5,500.00 | $277,326.07 |
| 46 | $5,500.00 | $305,012.15 |
| 47 | $5,500.00 | $334,913.13 |
| 48 | $5,500.00 | $367,206.18 |
| 49 | $5,500.00 | $402,082.67 |
| 50 | $6,500.00 | $440,749.28 |
| 51 | $6,500.00 | $482,509.23 |
| 52 | $6,500.00 | $527,609.96 |
| 53 | $6,500.00 | $576,318.76 |
| 54 | $6,500.00 | $628,924.26 |
| 55 | $6,500.00 | $685,738.20 |
| 56 | $6,500.00 | $747,097.26 |
| 57 | $6,500.00 | $813,365.04 |
| 58 | $6,500.00 | $884,934.24 |
| 59 | $6,500.00 | $962,228.98 |
| 60 | $6,500.00 | $1,045,707.30 |
| 61 | $6,500.00 | $1,135,863.89 |
| 62 | $6,500.00 | $1,233,233.00 |
| 63 | $6,500.00 | $1,338,391.64 |
| 64 | $6,500.00 | $1,451,962.97 |
| 65 | $6,500.00 | $1,574,620.00 |
| 66 | $6,500.00 | $1,707,089.60 |
| 67 | $6,500.00 | $1,850,156.77 |
| 68 | $6,500.00 | $2,004,669.31 |
| 69 | $6,500.00 | $2,171,542.86 |
| 70 | $6,500.00 | $2,351,766.29 |
The IRA balance doesn’t exceed the limit of bankruptcy protection until age 62.
The rollover
Most people roll their 401k over to an IRA when they leave their employer. Imagine you worked until 65 years old and retired. According to the first table, you’d have around $3.7M in your 401k. If you roll that over to your IRA you’ve suddenly put everything over $1,283,025 at risk in the event that you need to declare bankruptcy.
Obviously nobody expects to need to file bankruptcy, but the reality is that it happens. The bankruptcy protection of a 401k is especially important if you have a high balance in your account and:
- You have little or no medical insurance – the #1 cause of bankruptcy in the US is due to medical bills. A chronic health issue or a single major medical issue combined with little or no health insurance can easily result in bankruptcy.
- You either are or want to be an entrepreneur – when you’re starting a business you usually need to personally sign for/guarantee business loans (nobody is going to loan money to a business with no sales, profits, or credit history). If your business fails you might end up needing to declare bankruptcy.
Other advantages of a 401k
Although the bankruptcy protection is the biggest advantage of a 401k over an IRA, it’s not the only one. 401ks also offer superior flexibility in two ways.
401k loans
Most people know that one of the advantages to a 401k is that, if your plan allows it, you can take loans. Unlike with an IRA, you don’t need to use the loan for an approved purpose. You can withdraw money penalty-free from an IRA for college costs, to buy a home, for health insurance and/or medical expenses, and if you become disabled. A 401k loan can be used for anything.
A 401k is allowed to offer loans of up to $50,000 or 1/2 of your account balance, whichever is less. If you have a balance of $30,000 you could take a loan for up to $15,000 (1/2 the account balance). If you have a balance of $300,000 you could take a loan for up to $50,000 ($50,000 max). If you DO take a loan you have to pay it back with interest, and the loan must be completely repaid within 5 years (although this can be extended if you’re using the loan to purchase a house). The interest rate is low and there’s no credit check or underwriting process for the loan. This makes the 401k loan a reasonable backup plan if you need more cash than is available in your emergency fund.
Withdrawals at age 55 instead of 59.5
Another little-known advantage to a 401k is that you can make penalty-free withdrawals starting at 55 if you’ve separated from service (where “separated from service” includes quitting, getting laid off, getting fired, or any other way of leaving your employer). This is a big difference from an IRA, which doesn’t allow penalty-free withdrawals until age 59.5.
They key is that you must leave service anytime during or after the calendar year in which you turn 55. If you take early retirement at 54 then you wouldn’t be able to pull money from your 401k until you’re 59.5. But if you wait until the year you turn 55 to separate from service you’ll be able to start taking withdrawals immediately.
Note that this doesn’t mean you must retire. You could leave employer A in the year you turn 55 and start making penalty-free withdrawals from your employer A 401k, even if you then go work for employer B.
Another wrinkle – you’re only able to access the 401k of the employer you left at 55 or older. Let me explain. Let’s say you worked at employer X from age 22 to 50. You then leave your job with employer X, leave your 401k with employer X, and go to work at employer Y from age 50 to 55. From age 50 to 55 you contribute the maximum to your 401k at employer Y.
You then leave your job at employer Y. You are able to access the 401k balance from employer Y immediately (because you’re 55 and you just separated from service from employer Y). However, your 401k at employer X can’t be touched until you’re 59.5 years old (you weren’t 55 or older when you separated from service from employer X).
The solution is to ensure that every time you change jobs you roll your 401k from your previous employer to your new employer. In the example above you’d roll your 401k from employer X to employer Y. When you leave employer Y at age 55 your entire balance from employer X and employer Y would be available for penalty-free withdrawal.
Diversification
I’m not talking about asset allocation here. I’m talking about taking advantage of the fact that 401ks and IRAs have different rules & regulations. For example, I’m a big believer in having both traditional and Roth IRAs for the simple fact that nobody knows what taxes will be in the future. If taxes in the future are much lower than today then a traditional IRA would be a better choice. If taxes in the future are much higher than today then a Roth IRA would be a better choice.
Similarly, there’s no way to know how the laws for 401ks and IRAs might diverge in the future. Owning both types of accounts provides a bit of protection in case the laws for one type of account become decidedly less favorable in the future.
The major 401k disadvantage
There is one significant downside of a 401k – fewer investment options. The investment options in a 401k are usually limited to whatever your employer makes available. In fact, in order to comply with ERISA diversification and fiduciary requirements, your employer (or 401k provider) only needs to provide 3 options: a cash/cash equivalent (like a money market), an equity fund (S&P index, for example) and a fixed income option (usually a bond fund).
By contrast, an IRA allows you to invest in just about anything – individual stocks, mutual funds, bonds, real estate, even private equity collectibles if that’s your thing. And, in fact, it’s this sort of flexibility that allows some people to amass an IRA worth more than $100M.
Conclusion
It wasn’t until I started learning about specific rules for 401ks vs. IRAs that I realized that in many cases a 401k might be superior to an IRA.
Unfortunately, most financial advisors won’t tell you this, because most financial advisors make money based on assets under management (AUM). The firm that manages your IRA is always going to suggest you “consolidate” your accounts by rolling your 401k over to your IRA. This is great for them, as the more of your money they manage the more money they make.
My advice is to think carefully before rolling your 401k over to an IRA. Depending on your specific situation you might be better off leaving your money in your 401k.
Have you always rolled over your 401 to an IRA when you changed jobs? Did you know about the advantages of the 401k vs an IRA?