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Pitfalls Of The 401(k) Rollover

By: Frank Armstrong

*As seen on Forbes.

The predators are circling. With a tsunami of retirees an entire industry is poised to capture rollovers. With so many juicy targets of opportunity, it shouldn’t surprise you that abuses happen. But, they don’t have to happen to you.

As a quick review your choices upon either job changing or retirement boil down to four:

  1. Take the money, pay all the taxes and penalties then run with whatever balance is left.
  2. Leave the funds in the old employer plan.
  3. Roll the money over into a new qualified plan with a new employer.
  4. Roll the money over into an IRA.

Take the money and run

If you take choice number one, there’s no hope for you and you don’t need to read further. You will have given up your favored tax status, paid obscene levels of taxes on your lump sum distribution, and cannibalized your future retirement.

Leave The Funds In Your Old Employer’s Plan

Choice number two might be attractive if the plan allows it, is low cost, and provides great investment choices. You will keep your options open, preserve your qualified plan creditor proofing, continue your favorable tax treatment, and keep your money in play building future benefits. You don’t need to make an immediate decision. Take your time, study your options and make a good decision.  Haste makes waste.

Roll The Money Into Your New Employer’s Plan

If you are moving to a new employer and they have a great plan, you might consider rolling your existing plan balances into it. This may close out the option of a later IRA rollover for those balances, but otherwise has all the advantages of choice two, and it may be easier for you to manage a single account.

Keep in mind that a 401(k) plan usually requires participants to bear the cost of administration, record keeping and investment advice. A few employers subsidize all these expenses, but if your employer does not you probably will not receive any benefit associated with these costs.

The IRA Rollover

To be sure, there are great advantages to rolling over your 401(k) when you change jobs, or finally decide to retire. For starters, trying to manage half a dozen retirement accounts spread out among different organizations each with different menu choices and prices is a nightmare. So consolidation done right is generally a good thing.

For most employees choice four, the IRA rollover, will be the best choice. An IRA gives you complete control over the investments selected and the lowest cost possibilities. You may also find that an IRA gives you better control over distributions and beneficiary designations where estate planning is an issue.

But paradoxically the IRA Rollover choice may be the one subject to the most abuse by unscrupulous “advisors”. IRAs and Rollovers are not covered presently by the strict fiduciary standards of the Employee Retirement Income Security Act (ERISA). So, predators, unrestrained by fiduciary obligations all too often swoop in to sell expensive, high commission, proprietary, and unsuitable products. For instance, Variable Annuities provide no additional benefit inside an IRA and are typically high cost, high commission, proprietary products which are unsuitable for an IRA but often recommended. And, you would be best served to avoid load mutual funds or other high commission products.

In some cases, pension advisors routinely take IRA rollovers from the pension to put them into higher cost, higher profit IRAs. They may or may not be fiduciaries for the 401(k) but not for the IRA. So as the IRA manager with their Registered Representative or Insurance Agent hat on they are not held to the same high standards.

These abuses are so pervasive that the SEC, DOL and FINRA are all looking into regulatory remedies. This issue is part of a much larger discussion on the Fiduciary Standard and the heart and soul of the advice industry that is currently winding its way through the Congress and Regulators.  In the meantime buyer beware!

Your lowest cost choice for an IRA rollover would be to transfer your balance into an IRA with a custodian like Schwab, Vanguard, or Fidelity and then use any of their excellent low cost index funds or ETFs to build a globally diversified portfolio that meets your needs.

If you don’t feel comfortable managing your rollover, you can hire an investment advisor. While this increases cost, you might decide that you are likely to get a better outcome with a professional managing it for you. If that’s your choice, make sure you get a Fee Only Advisor that will assume fiduciary status for the account in writing.

Creditor Protection

If creditor protection is a major concern, check your state’s bankruptcy code to make sure that an IRA would be shielded against any potential claims. A qualified plan like a 401(k) enjoys federal exemption from most creditors. But an IRA is not a qualified plan and subject to state code. Some states like Florida offer almost complete protection, while other states offer virtually none. If the assets are significant, or the concern is great, get a legal opinion before you give up Federal Qualified Plan creditor protection.

Trustee to Trustee Transfer

Whatever kind of rollover you decide on, make sure it’s a trustee to trustee transfer where the money never passes through you hands. This avoids any nasty tax problems where you are considered to have received the funds for tax purposes at ordinary income rates.

Full Disclosure

My firm is an SEC Registered Investment Advisor, and a Fee Only Advisor that actively solicits IRA Rollovers from those that prefer to have a managed account.  While we use Schwab, Fidelity, and Vanguard funds among others, we have no financial incentives to use them.