The 401(k) balancing act

Key Points

  • An employer plan has undeniable benefits, but your retirement strategy doesn’t need to stop at that
  • When it comes to retirement investment options, it’s crucial to understand the difference between 401(k) and IRA plans
  • Depending on your circumstances, moving funds out of an employer plan could provide you with additional investment options, flexibility and tax advantages

It's not surprising that 401(k) plans make up the bulk of retirement savings for most Americans when you consider benefits such as pre-tax deductions and company matches. But employer-based plans can be limiting for those who want to invest more than the current annual contribution limit of $18,500 (2018).

Perhaps even more importantly, the preselected investment options in your plan may not be suited to your needs and goals.

retirement age vs account types graphic

If you'd like to take control of your employer-based investments before you retire, your plan may permit these two options:

  • The IRS allows after-tax contributions made to a 401(k) to be converted to a Roth IRA each year, enabling you to invest the funds as you like within a tax-free account.
  • At age 59½, you can roll all or part of a 401(k) into an IRA through an in-service distribution, allowing further expansion of investment options in the crucial preretirement phase of saving.

Benefits of moving funds out of an employer plan

  • Investment options: "Because the plan administrator chooses the investment lineup, an employer-based 401(k) is really a ‘one size fits all' model," says Amy Diesen, Vice President of Wealth Management Solutions at Ameriprise Financial. "With a self-directed IRA, you are an owner, rather than a participant, which means you can select from a variety of investment options tailored to your specific needs and goals."
  • Distribution flexibility: Some employer plans have limits on how many distributions can come out per year in retirement. "Your employer determines the rules for participants, and they may limit distributions to a single lump sum or a certain number per year," Diesen says. "With a self-directed IRA, you decide the timing of distributions."
  • Improved diversification: Many IRAs are built from 401(k) rollovers by those who have separated from service. "On average, people change jobs seven times in their career, resulting in what we call ‘401(k) orphans,'" Diesen says. "By consolidating investments in one place, assets can be managed and diversified by risk tolerance, tax liability, years to retirement and more."
  • Tax advantages: "The earnings on after-tax 401(k) contributions are taxable when you convert those funds into a Roth IRA," Diesen says. "Depending on your situation, converting every year could make sense rather than waiting for earnings to grow and then paying more taxes on them." Once those funds are in a Roth IRA, future earnings will grow tax-free if conditions are met.
"By consolidating investments in one place, assets can be managed and diversified by risk tolerance, tax liability, years to retirement and more." - Amy Diesen, Vice President of Wealth Management Solutions, Ameriprise Financial

Reasons you may not want to roll over funds

  • "If the investment costs in your 401(k) are relatively low and the plan has picked out a great assortment of funds, you may want to leave investments where they are," Diesen says.
  • You may also want to leave at least some funds in a 401(k) if you're retiring early. "If you retire at 55 or older, you can take distributions straight from a 401(k), while you have to wait until 59½ to draw on an IRA," Diesen says. "For those retiring earlier, we'd recommend leaving enough funds in the 401(k) to bridge those years."
  • Individuals with concerns about creditor protection should check with an attorney before rolling over. Assets rolled from a 401(k) plan to an IRA retain federal bankruptcy protection but creditor protection outside of bankruptcy is a matter of state law.
  • If you have highly appreciated employer stock in your 401(k), there may be an opportunity to utilize special tax treatment that is available for an in-kind distribution of employer stock from the plan. This special treatment is not available from an IRA.

In short, the pros and cons of investing outside of a 401(k) are going to differ depending on your individual needs and goals, and an advisor can help by looking at your bigger financial picture.

"A 401(k) may be sufficient if you're younger or in the ‘accumulation phase' of retirement saving, but you may want to explore a wider array of options when you're closer to retirement and thinking more about safety, tax-efficiency and making your money last," Diesen says.