This is a question virtually every retiree will need to ask as they near retirement. The advice on the subject may seem straightforward, but there are multiple conflicts of interest, unique considerations for your own circumstances, and various rules to navigate. This blog is intended to help you put the facts together to make an informed decision on what the best route is for you as you transition into retirement. It’s worth saying up front: financial advisors who manage assets (like us) have an inherent conflict of interest in making these recommendations to you. That being said, we often prefer simplicity when designing and recommending financial plans to our clients. Consolidating your retirement assets and utilizing the flexibility of an IRA is oftentimes an easy way to do that, whether you use an advisor or not.
Key Takeaways
- Employer-sponsored plans are standardized plans made for multiple levels of employees and are generally optimized for accumulation.
- Individual Retirement Accounts (IRAs) are accounts not tied to any employer; as such, your flexibility around most decisions is the greatest.
- A rollover can be an irrevocable decision, so understand the rules before doing so.
The difference between employer-sponsored plans and IRAs
Roughly half of employees working for private businesses in the United States will have access to an “employer-sponsored” retirement account, according to Plansponsor. These will be plans such as 401(k)s, SIMPLE IRAs, or SEP IRAs. Workers in public service, whether municipal or federal, may have access to a 403(b), 457(b), or Thrift Savings Plan (TSP). Why different plans? Different sections of the tax code apply depending on the type of employer you work for. Someone who works for a private business will never have a 403(b), as those are designated for nonprofit employers and public schools. The rules for employers can differ slightly.
For employees, the differences are, for the most part, moot. What these plans all have in common is the ability for employees to make payroll deductions. Often, that comes with a match or even profit sharing. In the United States, these types of employer-sponsored plans are the easiest way to maximize your compensation (by getting a match!), accumulate assets for the long term (your retirement!), and participate in capital markets with balanced risks using target-date or pre-selected funds. Like many benefits offered through employers, the size of these plans also often yields lower fees. In investing, this is a critical factor in predicting how well your investments will perform. Generally speaking, for young accumulators, participating in all of your group benefits is a great way to minimize the cost of retirement assets, insurance, and other benefits that may be offered.
What happens when you get to retirement?
We’ve written about establishing a withdrawal plan and investing during retirement. The logistics of taking money out can be difficult. The reality of employer-sponsored plans is that withdrawal options can vary. There isn’t necessarily a place in the tax code that dictates how easy or difficult it is for participants to set up ongoing distributions from their plans.
Notoriously, for years, the TSP had one of the most antiquated withdrawal methods of any employer-sponsored plan in the United States. You could only adjust your monthly distribution amount once a year. Things have changed with the TSP Modernization Act, but it still isn’t the easiest thing to deal with.
It’s worth examining your options for setting up distributions from an employer-sponsored plan. For those who have a 403(b) tax-sheltered annuity, things may be even uglier. In our own experience with clients, some plans require you to request paper forms that need notarization or signature guarantees to alter payout options. Some higher-education plans, such as TIAA-CREF, have guaranteed options that only let you withdraw 10% of the contract value per year over 10 years.
None of these are inherently bad on their own; most people just fail to ask the questions ahead of time. Lack of liquidity and flexibility makes any retirement cash-flow plan more complex.
Most times, whether clients are working with us and we’re managing their assets (again, we have a conflict of interest) or we’re doing hourly consulting, a recommendation we’ll make is rolling employer-sponsored funds to an IRA. If you have multiple employer-sponsored accounts, we’d recommend consolidating them into a single IRA.
The flexibility you are provided by an IRA custodian is about as wide as it gets. You can choose the method and frequency of any withdrawal, control the investments liquidated to make such a distribution, and of course control any investment choices you choose to pursue. You can read more about our own investment methodology here.
The rules you need to understand before you roll over
That’s our default recommendation, and you should know why before you act on it. A rollover isn’t automatic, and once it’s done, it usually can’t be undone.
We should add that, while this is our default stance, it isn’t uncommon for us to recommend leaving some money behind. Some plans, the TSP for example, let you roll money back in. Many plans will accept incoming rollovers. So if you’re “testing out” a financial advisor, this can be a way of leaving your options open. Just don’t forget about it!
Now for some of the rules that catch people off guard the most, and we see this all too frequently.
Net unrealized appreciation (NUA)
If your 401(k) holds employer stock, this is the first thing to check. NUA is a tax rule that lets you distribute that stock in-kind out of your plan, pay ordinary income tax only on its original cost basis, and pay long-term capital gains rates, not ordinary income rates, on everything it’s appreciated since. Roll that stock into an IRA instead, and you give up NUA permanently. Every dollar you eventually withdraw gets taxed as ordinary income, no exceptions. If you’ve held company stock for years and it’s appreciated meaningfully, this decision alone can be worth real money. We run the NUA numbers before we roll over any plan that holds employer stock, and you should be doing this too. It’s a tax strategy that can yield real savings, though concentration and investments should also be considered. This is very individual-dependent.
It’s worth noting that many people get NUA wrong, advisors included. To qualify, you need to take a lump-sum distribution of your entire plan balance within a single calendar year, and it has to follow a triggering event: separation from service, reaching age 59½, or death. The employer stock comes out in-kind to a taxable brokerage account, and the rest of the balance can still be rolled into an IRA. You also need to pay the tax on the cost basis of your original stock investment when you move the money, so that will require some cash to cover it upon distribution. This requires planning, especially if it’s a large balance. We’ve seen this reported incorrectly on tax returns, with the tax never paid. This isn’t something to try on your own. We talk a lot about marginal vs. effective rates, so the reality is that the numbers need to be run before making any decisions on rolling out employer stock.
The age 55 rule
If you’re retiring early, or already have, there are special rules for employer-sponsored plans. Separate from your employer in the year you turn 55 or later (50 for qualified public safety employees), and you can take penalty-free withdrawals directly from that employer’s 401(k) or 403(b). IRAs don’t offer this. Withdraw from an IRA before age 59½, and you owe a 10% early withdrawal penalty on top of ordinary income tax, with only a short list of exceptions. Roll your 401(k) into an IRA the year you retire at 56, and you’ve traded penalty-free access for a penalty you didn’t have before. If there’s any chance you’ll need this money before 59½, confirm you don’t need the rule of 55 before you roll anything over.
One more wrinkle for public employees: governmental 457(b) plans don’t carry the 10% early withdrawal penalty at all, at any age, once you’ve separated from service. Roll that money into an IRA, and it becomes subject to the penalty until 59½. If you’re retiring early from a government job, this can be one of the strongest reasons to leave your 457(b) money where it is.
Direct versus indirect rollovers
There are two ways to move money out of an employer plan, and one of them involves much less pain and worry than the other. A direct rollover moves funds from custodian to custodian. Sometimes the check gets mailed to you (looking at you, Fidelity 401(k)s!). You never touch the money, and nothing gets withheld. The check is made out to the custodian and can’t be deposited by you or another individual. You send the check to your custodian, or it’s mailed there automatically. It’s worth noting that getting your entire retirement plan balance in your mailbox can be a little bit of a scary proposition. An indirect rollover means the plan sends you a check, and by law they’re required to withhold 20% for federal taxes before they do. This check is made out to you, and it’s cashed by you. You then have 60 days to deposit the full original amount, including the 20% that was withheld, into an IRA, or the shortfall becomes a taxable distribution, and a penalized one if you’re under 59½. Most people who get burned here didn’t do anything wrong on purpose. They just didn’t realize the check was already short 20%, and they rolled over what they actually received instead of making up the difference out of pocket. Default to a direct rollover. There can be times when an indirect rollover makes sense, but they’re rare.
Creditor protection
This one gets overlooked constantly. Assets in an ERISA-governed employer plan, like a 401(k), have unlimited protection from creditors under federal law, both in and out of bankruptcy. Not every plan in the title is covered by ERISA. Governmental 403(b)s, 457(b)s, and the TSP fall under separate rules, though they generally carry strong protection of their own.
IRAs are protected too, but not in the same way. In bankruptcy, federal law protects IRA assets you’ve contributed up to $1,711,975 (adjusted every three years for inflation), but money rolled over from an employer plan doesn’t count toward that cap and remains fully protected. It can be worth keeping rollover money in its own IRA rather than mixing it with annual contributions, so it’s easy to document where it came from. The bigger difference is outside of bankruptcy, like a lawsuit or judgment, where IRA protection depends entirely on your state’s laws. Delaware and Maryland both offer meaningful protection for IRA assets, but neither is unlimited, and neither is automatic. If you’re in a profession with real liability exposure, this is worth a conversation before you roll over, not after.
RMDs and the still-working exception
If you’re still working past your RMD age (73 if you were born between 1951 and 1959, moving to 75 for those born in 1960 or later) and you own less than 5% of the company, your employer’s plan may let you delay RMDs from that plan until you actually stop working. IRAs don’t offer this exception under any circumstances. Once you reach your RMD age, you’re taking distributions from every traditional IRA you own, working or not. If you’re still earning income and would rather not add an unnecessary RMD on top of it, that’s a real reason to leave money in the employer plan a little longer. People ask how they can delay RMDs; an easy way is to work for an employer with a retirement plan and put all your money there. The trade-off of course is that you have to work.
Fees and investment options
We’d be doing you a disservice if we only told you the case for rolling over. Because employer plans pool assets across every participant, they often negotiate institutional pricing you can’t access on your own, meaning lower total cost than what’s typically available inside an IRA. This isn’t always true, but it’s worth understanding. This is true of most benefits provided via an employer. What you give up is choice. Employer plans usually offer a curated list of funds, often somewhere between 15 and 30 options. An IRA opens up essentially the entire investable universe: individual stocks and bonds, any fund family, any strategy you want to pursue. For some people, a limited, low-cost menu is exactly what they need. For others, especially those who want a portfolio actively managed around valuation or tax considerations, the flexibility of an IRA is worth more than the fee difference. Oftentimes, as we find with our clients, the personalized advice and planning is what a 401(k) doesn’t offer. We are paid via the assets we manage because we implement much of the planning and advice and orchestrate the logistics of your retirement income. Your 401(k) more than likely won’t offer those benefits. (Not a sales pitch, just saying.)
Where this leaves you
Whew, long blog post! That said, none of this changes our answer for most people. For most retirees, once you’ve confirmed you don’t need penalty-free access before 59½, checked for employer stock, and understood what you’re giving up on the RMD and creditor protection side, a direct IRA rollover is still usually the right move. The flexibility it gives you over withdrawals, investment choices, tax planning, and beneficiary designations is hard to replicate inside an employer plan. Just don’t sign the paperwork until you’ve walked through these rules for your own situation. That’s the whole point of this piece. Unlike most financial decisions, this one is genuinely hard to take back. Make an informed choice.
