Why a 401(k) rollover to an IRA could be a mistake

If you leave a job or retire, you’re often encouraged to roll over your 401(k) or other workplace retirement account into an individual retirement account. That might not be the right move.

Workplace plans have rules that can protect you from subpar investments and advisers who put their own interests ahead of yours. IRA investments can be more expensive, which can result in less money to spend in retirement. Workplace plans also may offer easier access to your money.

IRAs typically offer many more investment options, a fact heavily emphasized by the financial services companies that want your money. Rollovers are big business — the Investment Company Institute, a trade group, reports that households transferred $463 billion from employer-sponsored plans to IRAs in 2017, the latest year for which statistics are available.

But just having more investment choices isn’t necessarily better.

"With a 401(k), your options are typically going to be more limited, but your options are also going to be squarely within your best interest," says Dylan Bruce, financial services counsel for the Consumer Federation of America, a nonprofit consumer advocacy group.

Fiduciary standards matter

You usually have choices about what to do with your retirement funds when you leave a job, and an IRA rollover is only one way to preserve the money’s tax-deferred status. Other ways include leaving the account where it is (your former employer must allow this if your balance is over $5,000) or rolling the money into a new employer’s retirement plan, if that plan accepts such transfers.

Most workplace retirement plans are covered under the Employee Retirement Income Security Act, which imposes a fiduciary duty on the people and companies overseeing the plans to operate solely in the interests of the participants and avoid conflicts of interest.

In the past, advisers weren't held to the same standard when recommending IRA rollovers, although that's changing. The U.S. Department of Labor is gradually extending fiduciary coverage to IRA rollovers starting this year, Bruce says.

Workplace plans may cost less

IRAs are sometimes touted as being cheaper than 401(k)s on average, but often that’s not the case. According to the Investment Company Institute, The average expense ratio for stock mutual funds in the U.S. in 2020 was 1.16%, while 401(k) investors paid about one-third that amount, or 0.39%, on average. Expense ratios are the annual fees charged for operating and administering the funds.

Fees make a big difference. Let’s say you invest $20,000 in a fund with a 1.16% expense ratio that grows an average of 8% each year. After 40 years, you’d have about $282,000. With a 0.39% fee, your balance would be nearly $376,000, or one-third more.

Accessing your money can be harder with an IRA, as well. You can’t borrow money from an IRA for longer than 60 days, or it’s considered a taxable distribution. Any money you withdraw before age 59 1/2 is typically penalized as well as taxed, although the penalty is waived for certain withdrawals, such as for higher education or a first-home purchase.

With 401(k)s, by contrast, you can begin withdrawing money at age 55 without penalties if you no longer work for the company offering the plan. If you transfer an old 401(k) account to a new employer’s plan, you typically can borrow up to half of your total vested balance or $50,000, whichever is less, and pay the money back over five years.

Furthermore, your 401(k) is also generally protected from creditors. Protection for IRAs varies based on state law.

When a rollover makes sense

Many people don’t want to leave money behind at their previous employer, and a rollover is a better option than cashing out. A rollover could be prudent if you don’t have access to a low-cost 401(k), you want to consolidate multiple retirement accounts, your investment options are too limited or the adviser recommending the rollover is a fiduciary (and willing to put that in writing).

It’s essential to investigate all your options, though

"It's probably going to be for most folks one of the most important financial decisions of their lives," Bruce says.

Liz Weston writes for NerdWallet. Email: lweston@nerdwallet.com. Twitter: @lizweston.