Where should you rollover your 401k?
One of your first encounters with the archaic U.S. financial system will occur the first time you need to rollover your 401k/403b. The process is incredibly confusing, involves coordinating with multiple brokerage firms, and can take anywhere from a few days to over a week to complete. In the age of the internet (and crypto), why are we still sending checks with thousands of dollars in the mail? This confusing process must be dealt with carefully because your choices during this 2 week period could impact your net worth significantly over your lifetime.
One of the most important decision points during this rollover process is choosing the new home for your funds. Your typical options are your new employer’s 401k/403b, a Roth IRA, or a Traditional/Rollover IRA. The critical factors in this decision process can be boiled down to autonomy, customer service, diversity of funds, the frequency your funds move, and taxes.
Note: If this terminology is foreign to you, please start with my previous article where I introduce these account types and how I allocate my investments between them.
Autonomy
Perhaps the most important differentiator between these options is that the 401k/403b is chosen by your employer, while the brokerage firm that manages your IRA is chosen by you. This level of autonomy is huge because you have the power to shop around for the best brokerage firms on the market. The best ones have zero trading commission fees, a multitude of fund options, an intuitive web interface and mobile app, robust 2-factor authentication options, and more. I’ll get you started on this selection process by recommending that you consider Fidelity and move TD Ameritrade down your list. TD Ameritrade has an awful user interface that requires separate log-ins for each account you have with them. Here is a previous article where I dive into the important factors to consider when choosing an IRA provider.
Customer Service
Good customer service is like insurance. You might never need it, but if any issues arise, you will be glad you have it. If you are unsure about whether the brokerage firm has good customer service, try contacting them to ask a question and see how long it takes to get help over the phone. No, I am not talking about the automated responses via the phone or an AI chatbot on the other end. How long does it take to get an actual human on the other end of the communication line? Anything more than 15 minutes can be extremely frustrating, especially if the organization has limited hours for customer service. Take a look at the screenshots below that compare Voya, a 401k provider, to Fidelity in terms of customer service hours. You’ll notice that Fidelity is 24/7 in terms of assistance, while Voya is much more limited.
Note: Yes, Fidelity can also be a 401k provider. The point is that you cannot choose whether Fidelity is your 401k provider.
Diversity of Funds
When you first register an account for a 401k/403b, you will often receive a packet of information and access to the prospectus for each fund that is offered. The amount of material is overwhelming to say the least. I would argue that this method of disseminating information is somewhat unethical. While recently going through this process with my girlfriend, I noticed that her 401k packet did NOT include expense ratio information for the funds being offered. This would be akin to going to Chipotle and not seeing prices on the menu. ETFs are able to summarize all of the essential information in 2 page factsheets, while this 401k provider failed to include expense ratios in their 10+ page welcome packet.
When it comes to fund options, you will notice that most 401k/403b providers include a limited set of about 10 to 30 funds. While the majority of investors do not need to invest in dozens of different funds, there are benefits to having more options. One of the most important criteria while shopping around is looking at each fund’s expense ratio. Many IRA providers offer funds with zero or low cost expense ratios (i.e. <0.20% expense ratio) as opposed to 401k/403b providers who often limit you to funds that cost 50+ basis points. An extra 50 basis points in expenses could cost you an extra 50,000 dollars over 30 years*.
*Assuming \$10,000 initial funds, \$5,000 contribution each year, a 7% annual growth rate, and a .01% expense ratio compared to a 0.5% expense ratio over 30 years.
Frequency Your Funds Move
Because of the archaic U.S financial system, whenever you rollover your funds, they will likely not be invested in the market for 3 to 14 days. While some brokerage firms offer a direct wire transfer that only takes a few days, others will only send you a check. For the latter, you are required to send the check to the new brokerage firm after you receive it. Only once the investments arrive at the new brokerage firm can you now choose your new funds to invest in — they likely remain in cash until you act. How important is this time that your cash is NOT invested in any stocks or bonds? If you missed the 10 best days in the market from 2003 to 2018, your annualized return during that time would drop from 7.7 percent to 2.65 percent. If you only invested 10,000 dollars at the start, this would cost you 15,000 dollars over 20 years.
Ideally, you never want your cash to not be invested in the market because it is impossible to time the market. If you rollover your funds from one 401k/403b to another 401k/403b, you are much more likely to need to move the funds again (i.e. due to a job change/consolidation) than if you moved these funds to an IRA. Alternatively, if you never rollover your funds then you might be left with managing investments across many different providers. That could be very time consuming and potentially costly for plan administration fees. Establishing a process that always rolls over funds to your IRA(s) will keep the majority of your funds invested in the market for more time than rolling over to the new 401k each time. The investments I rolled over into a Roth IRA in 2015 have continuously been invested in the market, while my most recent employer’s 401k investments had to be moved once I left the organization. The result was added time where my investments were not invested in the market. This is a potential tail risk that I was forced to experience.
Taxes
Virtually every IRA provider allows you the option to open a Roth IRA (after-tax) and/or a Traditional IRA (pre-tax). The same cannot be said for 401k/403b providers where the roth (after-tax) contribution is only offered occasionally. Having the option to distribute funds into both pre-tax and after-tax accounts gives you increased flexibility on when and how much you pay in taxes. This optionality could be important at different times in your life. For retirees, Roth IRA accounts provide additional flexibility since they do not have required minimum distributions.
Some additional things to remember during this process:
- If you rollover funds from a pre-tax account (e.g. Traditional 401k) to an after-tax account (e.g. Roth IRA) you would have to pay taxes on your gains.
- Rollovers to IRAs do not count to your contribution limits
- Contributions to IRAs are not tax deductible in all situations nor available for everyone. There are restrictions to certain individuals and households based on income levels and other factors.
Conclusion
You’ll notice that I did not mention any advantages of the 401k over the IRA as the account to receive your rollover funds. Personally, I have never once rolled over funds from a previous employer’s 401k to the new employer’s 401k. I believe there are clear monetary advantages for choosing to rollover your funds to an IRA over your new employer’s 401k/403b. However, many of these benefits assume that you choose a good IRA provider so researching different IRA providers is a must before choosing one. I highly recommend that you spend the necessary time doing your due diligence during this process because these decisions will have a large impact on your investments and net worth.
Financial Disclosure: Please note the website disclosure — none of this is financial advice.