By Katie Cuccia Hebert

When changing jobs, you are presented with several options regarding your 401(k): cash it out, leave it where it is, roll it over into your new 401(k), or roll it over into an individual retirement account (IRA).

If possible, try to avoid cashing out your 401(k), as it subjects you to penalties if you’re under 59 ½. It can also leave you with a large tax bill since distributions are considered income and are taxed at your ordinary income tax rate.

Leaving the 401(k) with your former employer means that no one is looking over your account to ensure it is invested correctly and aligned with your goals and financial plan. Meanwhile, combining your old and new 401(k) can be complicated and lacks professional management of your account.

The fourth option, rolling over your 401(k) into an IRA, offers numerous advantages:

• Professional management

• Greater investment selection

• Greater flexibility

• Better communication

• Roth IRA conversion options

• Estate planning for heirs

Professional Management

You save into your 401(k) not only to take advantage of the “free money” you are receiving in the employer match but also to ensure you have money to live on in retirement.

Given that you work toward the ultimate goal of retirement for a large portion of your life, you want to make certain that you can have a successful retirement that you enjoy and not run out of money.

This is a common reason why people work with a financial advisor; they want to know that everything they are working toward is feasible, and if it is not, what adjustments they can make along the way to meet their end goal. Professional management of investment accounts, especially retirement accounts, provides you with investment, tax-saving, and income strategies that are typically not available with a 401(k) provider.

Working with a financial advisor doesn’t just have the potential to improve your investment experience. It can also provide peace of mind knowing that you always have someone you can reach out to with questions and concerns—someone who truly understands your long-term goals and retirement plan objectives.

Greater Investment Selection

It is common for 401(k)s to offer few stock or bond mutual funds to choose from. There may even be only one mutual fund option per asset class, or not all asset classes may be represented. This could result in your 401(k) being improperly allocated or overweighted in one area, meaning you are investing too much in one asset class or area of the market.

However, an IRA does not have those limitations. With an IRA, you have a wide array of investment choices that are not available inside your 401(k)—such as individual stocks and bonds, exchange-traded funds (ETFs), and real estate. You can also invest in mutual funds from a variety of fund families (American Funds, Vanguard, etc.). Not being restricted to specific funds or investment types may have a positive impact on your portfolio over the long run.

Greater Flexibility

Not only does an IRA provide for greater investment selection, but it also allows you to rebalance, or buy and sell, your holdings anytime you want. Many 401(k)s limit the number of times per year a participant can rebalance their account. Consistently buying and selling, especially at the wrong times, could negatively affect your portfolio over time.

One often-overlooked difference between a 401(k) and an IRA is the required tax withholding on 401(k) distributions. The IRS requires that 20% federal taxes be withheld from 401(k) distributions. With multiple withdrawals from your 401(k), the automatic 20% federal tax withholding can deplete your account over time.

There is no automatic or mandatory tax withholding from an IRA distribution. You can choose not to withhold taxes or choose to withhold an amount that more accurately reflects the amount you actually owe. This prevents the account from depleting as quickly while allowing more money to continue to grow.

Better Communication

When you leave an employer, it may be tough to stay up to date with information regarding your plan. News is frequently delivered through company email, which you probably no longer have, and it may be difficult to get in touch with the 401(k) administrator or provider. While this is not intentional, it can be frustrating for you not to know what is going on with the plan and your account.

Having access to information and staying informed is vital if something happens with your former employer, such as a plan termination.

With an IRA account, there is no such lag time in communication. The custodian (the company that holds your IRA assets) will contact you in a timely manner with any material information regarding the company or your account.

Roth IRA Conversion

While Roth 401(k)s are gaining in popularity for their potential tax advantages, the default 401(k) contribution option is pre-tax, meaning you have not paid taxes on any of the money you have contributed to your 401(k). To roll over your 401(k) into a Roth IRA, you first must roll over the funds into a traditional IRA. Then you can convert the traditional IRA to a Roth IRA.

However, in doing this, you will be taxed at your ordinary income tax rate on the amount you convert in the year of the conversion since you previously received a tax deduction for your contributions. If the amount you wish to convert is large, it may be more tax-efficient to convert only a smaller amount of your IRA each year, rather than converting the entire account at once.

A Roth IRA can be advantageous if you think tax rates will be higher or if you believe you will be in a higher tax bracket when you start withdrawing money from your IRA.

In a Roth IRA, the gains grow tax-deferred and are withdrawn tax-free if the funds have been in the account for five years and you are over age 59 ½. For those who need to withdraw funds before age 59 ½, it is easier to withdraw funds from a Roth IRA than a traditional IRA as there is no early withdrawal penalty to access your contributions.

Owners of a Roth IRA are also exempt from required minimum distributions (RMDs), which begin at age 72.

It is important to work with your financial and tax advisor when converting a traditional IRA to a Roth IRA so this can be done with the least amount of tax consequences. While a Roth IRA has tax benefits, a conversion may not be helpful if you face significant unfavorable tax consequences.

Estate Planning for Heirs

It is common for a 401(k) to be paid out in a lump sum to a beneficiary at the account holder’s death. While this rule varies from plan to plan, most companies prefer to distribute the 401(k) in a lump sum so they do not have to maintain the account of an employee who is no longer there.

A lump sum payout can subject the beneficiary to income and inheritance tax that they may not have faced had another death claim option been available. An IRA offers more payout options that may save your beneficiary a substantial amount in taxes.

Understand What Is Right for Your Situation

You have many factors to consider when determining what to do with your 401(k). Speaking with a financial advisor can help you understand your options and determine which ones are right for you.

If you have experienced a change in employment or are nearing retirement and want to speak with a financial planner about the action steps you should take, schedule a complimentary 30-minute discovery call with one of our CERTIFIED FINANCIAL PLANNER™ professionals.