What's the Best Move for Your 401(k) After Retirement?

One of the significant financial choices facing older employees is deciding what to do with their 401(k) plan after they retire.

Individuals usually face two choices when dealing with their retirement savings: They can transfer these funds into an individual retirement account. Alternatively, they may opt to keep the money within their previous employer’s plan. (Naturally, they could also choose to withdraw the entire amount as cash; however, this option frequently proves less favorable due to the likely tax liabilities and possible penalties involved.)

In 2023, approximately 25 million households held Individual Retirement Accounts (IRAs) containing funds transferred from previous workplace pension plans, as reported by the Investment Company Institute. Nevertheless, firms are progressively advising ex-employees to keep their retirement savings within the organization's plan. Data provided by the Vanguard Group indicates that nearly half of all individuals who changed jobs last year opted to retain their funds in their old employer's 401(k). Additionally, roughly one-quarter of those aged 60 and above maintained their balances in these accounts even five years post-departure.

This decision requires thoughtful consideration due to significant yet often overlooked outcomes associated with every alternative. My research alongside John Turner and Catherine Reilly recently delved into the primary factors influencing this choice. Below is an examination of the benefits each option presents.

Transferring funds into an IRA

• You'll probably have access to a wider range of investments.

A major advantage of transferring your 401(k) to an Individual Retirement Account (IRA) is gaining access to a wider range of investment opportunities. Unlike most 401(k) plans, which often have limited selections, IRAs usually offer a broader array of investments, such as Exchange-Traded Funds (ETFs). Many ETFs, especially those tracking indexes, come with lower expense ratios compared to typical 401(k) offerings; however, many workplace retirement accounts still do not incorporate these cost-effective options.

Moreover, someone retiring who wishes to purchase individual stocks and bonds might consider doing this within an IRA since 401(k) plans generally prefer mutual funds (although some permit access to personal investments through brokerage accounts). Additionally, IRAs have the capability of holding "non-traditional" assets such as precious metals, actual property, and hedge funds—investment options often excluded from workplace retirement programs.

• You can simplify your account management.

Individuals who have multiple 401(k) accounts from previous employers can simplify their finances by consolidating these into a single IRA. Doing so makes it simpler to oversee your investment portfolio and monitor your assets. Additionally, you will not have to remember different account numbers and passwords.

Indeed, most 401(k) plans permit you to transfer retirement savings from previous jobs into your present 401(k). However, funds in an IRA will stay apart from this consolidation.

Reducing the number of retirement accounts can make things easier for your spouse or children when they need to assist you with significant choices related to elder care, assisted living facilities, and estate management. It will also be beneficial as they handle matters concerning your estate. For example, after my elderly parents passed away, I spent a whole year organizing and combining their numerous (minor) financial accounts.

• Typically, you'll enjoy more flexible payout options.

IRAs typically provide greater flexibility when it comes to withdrawal options compared to 401(k)s. For example, your previous employer might limit the amount and frequency of withdrawals from your 401(k), as well as dictate that these sums cannot change over time.

On the other hand, retirees have the flexibility to withdraw whatever amount they choose from their IRAs without having to prove financial distress to receive a distribution. Keep in mind that withdrawals from an IRA must be reported as part of your taxable income, and you will incur a 10% tax penalty if you make withdrawals before reaching the age of 59½.

Using an Individual Retirement Account (IRA), you have the option to buy an annuity that provides a consistent income flow throughout your lifetime. In contrast, only a limited number of 401(k) plans presently feature payout annuities within their selection of investments. Nevertheless, this scenario is evolving due to regulations set forth by the Secure Act and Secure 2.0 Act, which permit plan administrators to incorporate payout annuities into 401(k) options. As a result, multiple firms are beginning to introduce these types of products.

Another factor to consider is that certain financial advisors could have an inclination towards avoiding lifetime income products within IRAs because they stand to gain larger commissions by directing their clients toward alternatives like annuities instead. However, this issue might become less prevalent with a recent regulation introduced by the Labor Department mandating that those providing rollover guidance must prioritize the client's interests. Nonetheless, this directive faces opposition from insurance organizations and advisory bodies which contend that such rules would complicate access to annuity options for consumers.

Sticking with your 401(k)

• The amount you spend and your investment fees might be reduced.

Company-provided 401(k) plans usually provide cheaper investment and advisory costs than Individual Retirement Accounts (IRAs). Because of this, keeping funds within an employer’s retirement scheme might assist retirees in generating higher returns on their savings.

For example, our research found that retirees enrolled in a major employer plan (having over $1 billion in assets) who transfer their funds to an IRA may incur extra annual investment administration fees amounting to 0.35% of managed assets. Usually, such plans impose charges ranging from 0.20% to 0.25% yearly for advisor services, whereas IRAs can have costs as high as 1% of total assets per annum. These reduced fees within the IRA might negate potential benefits gained from using low-fee ETFs inside the account, based on what portion of your wealth is allocated towards these ETFs.

Robo-advisors typically charge lower fees—ranging from one-quarter to one-half of a percent annually based on your total investments—and may be suitable for individuals with modest account sizes. However, they generally provide fewer investment choices compared to traditional advisory services.

Many 401(k) plans probably provide access to cost-effective target-date funds which modify the investment strategy based on how old you get. Consequently, senior individuals within these programs shift towards more secure investments over time without needing to personally intervene—unlike with IRAs. However, despite this automatic adjustment feature, total expenses may still vary among different company-sponsored schemes; hence, conducting personal evaluations remains essential.

A further advantage of the 401(k) plan is that many employers are making efforts to retain 401(k) accounts post-retirement for their workers. This strategy helps them achieve greater cost efficiencies across the board, reducing expenses for current employees as well as retirees. Large corporations have an edge here because they can secure reduced charges from service providers like record-keepers and asset managers, which individual IRA holders typically cannot accomplish independently.

• You receive stronger financial safeguards.

Stashing your retirement funds in a 401(k) plan offers a degree of fiduciary security that isn’t always provided by numerous financial advisors. This is due to the fact that the organization administering the 401(k) has legal obligations to prioritize the interests of those participating in the plan. In particular, employers have a legal duty to manage the investment options and cost structures within the 401(k) plans for individuals who continue to participate in them.

In the meantime, the rules governing fiduciaries for independent advisors helping with decisions about rolling over an IRA continue to be uncertain.

An associated element is that funds within a 401(k) are safeguarded from bankruptcy claims under the law, whereas money in an IRA does not have this protection. This distinction ought to be a crucial point for individuals who might encounter fiscal difficulties as they age.

• You can access the funds earlier.

For individuals who require accessing their retirement funds earlier than planned, 401(k)s typically provide a significant benefit. This is due to numerous employer-based programs permitting withdrawals from 401(k)s starting at age 55 without incurring penalties. In contrast, for IRAs, the minimum age for withdrawing funds without facing tax penalties is 59½.

One aspect that appeals to me and numerous other veteran staff members is the ability to postpone mandatory withdrawals from our 401(k)s as long as we remain employed with the companies providing these plans, all while delaying taxes. In comparison, traditional IRAs mandate that older workers begin withdrawing funds at age 72 (or age 73 if their birthdate falls after December 31, 2022).

Additionally, certain employers permit retired individuals to keep their funds within the 401(k) plan, thereby allowing them to borrow from these accounts. This arrangement enables retirees to obtain immediate liquidity without facing withdrawal penalties or paying taxes upfront on the withdrawn amount.

• You won’t feel bombarded by choices.

A wide array of investment options can be overwhelming for most retired individuals lacking financial knowledge, causing them to make unwise investment and expenditure choices. My previous studies revealed that numerous people aged 50 and above lack an understanding of fundamental concepts like risk diversification, asset evaluation, portfolio selection, and investment costs. Furthermore, my work indicates that those most susceptible to these deficiencies include women, less educated individuals, minorities, and people aged 75 and older, who frequently possess smaller amounts of retirement funds.

For these people, the simpler option would be to stick with their 401(k), rather than transferring funds into an IRA.

Individuals who hold IRA accounts usually have the duty to manage their funds themselves, which involves keeping track of the tax implications of buying niche investments. As such, those retirees who lack financial expertise and possess uncommon holdings might encounter more complex tax scenarios within their IRAs, especially if they do not collaborate with a tax professional.

Other considerations

Another crucial aspect for senior employees to ponder when choosing between the alternatives is estate planning, along with understanding how regulations affect their retirement savings upon passing away.

The funds in your IRA will be transferred to the designated beneficiary if one has been chosen; otherwise, they will revert to your estate. For a 401(k) account, upon the participant's death, at least fifty percent of the remaining assets must be distributed to their surviving spouse, assuming there is one, unless explicit consent was granted previously for those funds to be allocated elsewhere. The benefit of these rules varies based on individual circumstances and personal preference.

Furthermore, an heir other than a spouse typically needs to claim the leftover funds from a 401(k) account within a decade and cover the associated tax liabilities during this period. Should a retiree neglect to designate a beneficiary for their 401(k) and leaves behind no living spouse, these assets usually become part of their estate and proceed through probate. This process can be intricate and tends to incur significant costs.

Ultimately, for many individuals, the decision should hinge on their level of financial literacy, the amount of money they've accumulated in their 401(k), as well as the structure and costs associated with the alternative options.

Individuals with substantial account balances might appreciate the wide range of investment choices offered by IRAs. Conversely, those with modest retirement savings could be better off using their 401(k)s due to possibly lower expenses and stronger fiduciary safeguards they provide.

Individuals enrolled in expensive 401(k) plans may find it more advantageous to transfer their investments into IRAs. Conversely, those who participate in large, low-fee 401(k) plans might be best served staying within these programs during retirement as they typically offer sufficient investment options. Additionally, participants can expect reduced fees for management services, enjoy the security of having their employers act under fiduciary duty, and gain peace of mind knowing their assets are protected against bankruptcy.

Above all, this significant financial choice should not be underestimated. Remember, it involves your well-earned savings.

Olivia S. Mitchell serves as the International Foundation of Employee Benefit Plans professor of insurance/risk management and business economics/policy at the Wharton School of the University of Pennsylvania. You may contact her via email at reports@wsj.com.