Pros and cons of employer plan-to-IRA rollovers
In June’s article, I talked about one of the most commonly asked about topics in retirement planning; when to start Social Security.
This month, I’m going to address another very common question many have when planning their retirements; whether or not to rollover an employer retirement plan like a 401(k), 403(b), etc. to an IRA.
First, let me give some background to the jumble of letters and numbers that refer to these various account types.
I’ll start with an IRA. IRA technically stands for Individual Retirement Arrangement, but most people refer to it as an Individual Retirement Account.
It’s a form of investment account that anyone can open, regardless of whether they are currently employed. However, people can only directly contribute to an IRA if they have “earned income;” income from wages or self-employment.
Additionally, people can “roll” money from other retirement plans (such as the employer-based plans I’m about to discuss) into an IRA. Unlike with making direct contributions to an IRA, a person does NOT need to be employed to roll money into an IRA from another plan.
IRAs have special treatment. With “traditional” or “pre-tax” IRAs, the money in the account typically has not yet been taxed. This is because when money was originally contributed, those contributions were tax-deferred, meaning the person who made the contribution opted to defer the recognition of income tax on that money until some point later; when they eventually take money out of the IRA.
IRAs can also be of the “Roth” tax status. The tax treatment of Roth IRAs is basically the opposite of traditional IRAs. When contributing money to a Roth IRA, there is no tax deferral on the contribution; the contribution comes from money that’s already been taxed. However, when the money is eventually distributed from the Roth IRA, it is typically tax-free, assuming the person is at least 59 ½ and has had a Roth IRA for at least five years.
The key thing to keep in mind with IRAs is that the “I” stands for “Individual.” Basically, it’s an account that’s yours that you can open and keep regardless of your employment status, whether you change jobs, retire, etc.
On the other hand, there are various types of employer-based retirement accounts that people can only open and fund through their employment with their employer. While these accounts all have their own unique aspects, at a high level, they are largely the same; they allow the employee and/or employer to put money into the account so it can be invested, grow over time, and eventually be taken out by the employee in retirement.
The different employer-based retirement accounts are:
- 401(k) – a plan commonly offered to those who work for companies in the private sector
- 403(b) – a plan often offered to those who work for certain public employers, most commonly public schools and certain tax-exempt organizations such as universities, churches and some hospital systems
- 401(a) – a plan generally offered to those who work for local and municipal government agencies, educational institutions and some non-profit organizations
- 457 – another type of plan that can be offered to certain state and local governmental employees. It would technically be a 457(b) or 457(f)
- TSP (“Thrift Savings Plan”) – a plan offered to federal employees
Depending on the person’s employer, they may have access to multiple plan types. For example, employees of public universities may have both a 403(b) and a 401(a).
Also, many employers offer a Roth version of their retirement plan, along with a traditional pre-tax version.
To further complicate things, some employers – typically smaller employers – may instead offer retirement plans that are built on the IRA chassis, unlike the plan types mentioned above. Specifically, these plans would be:
- SEP IRA (“Simplified Employee Pension” IRA) – employers open up IRAs for their employees that the employer can then contribute to. Employees do NOT make contributions to SEP IRA
- SIMPLE IRA (“Savings Incentive Match Plan for Employees” IRA) – similar to a SEP IRA, except that both employers AND employees can contribute to SIMPLE IRAs
I won’t dig much further into SEP and SIMPLE IRAs other than to say they are popular with smaller employers because they are often easier and less costly to administer since they are ultimately IRAs as opposed to larger and more complicated formal retirement plans like the other plan types mentioned above.
Okay, let’s now move on to the actual topic at hand; deciding whether it makes sense for you to roll over your employer plan to an IRA (or Roth IRA, assuming you have Roth money within your employer plan).
For purposes of this article, I’ll assume you’ve since retired, which is why you’re considering rolling money out from your employer plan.
However, it should be noted that it’s possible you might be able to rollover money even before you retire. For example, perhaps you’ve changed jobs from Employer A to Employer B, and you’re trying to decide what to do with your old 401(k) at Employer A. Should you keep it there? Roll it to an IRA? Or even roll it to the retirement plan offered by Employer B???
Another scenario where you may be considering a rollover but still working is if your current employer allows “in-service” distributions; i.e. taking or rolling money out of the employer’s retirement plan even though you’re still actively working there.
Anyway, for the rest of this article, I’ll assume you’ve since stopped working completely, which is why you’re considering moving money out of the employer plan into an IRA.
I’m going to break it down by summarizing the potential pros or benefits of doing a rollover to an IRA (or Roth IRA), and then also summarizing the potential cons or drawbacks of rolling the money out.
POTENTIAL PROS OR BENEFITS of rolling money out of your employer plan to an IRA (or Roth IRA):
More investment options – most employer retirement plans have a limited menu of investment options you can choose within the plan. However, in an IRA, you can invest in virtually anything. The only things the IRS strictly prohibits from being held within an IRA is 1) life insurance and 2) collectibles.
Practically speaking, most of you won’t invest in anything too exotic or off the beaten path within your IRAs. Presumably you’ll keep your investments limited to traditional financial securities like stocks, bonds, mutual funds, exchange traded funds, etc. With that said, many employer plans – especially plans of larger employers – have a wide enough selection of investments for most people’s needs. However, when investing in an IRA, you nonetheless have a much wider array of investments to choose from.
Likely lower fees and costs – employer plans typically charge participants some kind of ongoing administrative or maintenance fee. These fees could be a fixed dollar amount per year, or they could be a percentage of your assets within the plan. For larger plans, these fees are typically rather small; often under $100 per year per participant. But for smaller plans, fees could be higher as there are less participants across which to spread the plan’s fees.
On the other hand, most of the major IRA custodians (e.g. Fidelity, Schwab, Vanguard) don’t charge any fees to open or maintain IRAs. As such, there is no ongoing administrative or maintenance fee with most IRAs.
Also, the built-in fees of the investment options are likely going to be lower in an IRA. Or at least they could be, depending how you choose to invest your IRA. For example, an S&P 500 index fund within your employer plan may have an annual “expense ratio” of 0.10% that’s deducted from your account balance. Conversely, within an IRA, you can buy one of multiple S&P 500 index mutual funds or exchange traded funds whose annual expense ratio is under 0.05% per year.
However, it’s possible that some employer plans could actually have slightly lower expense ratios than funds you’d be able to buy on your own in an IRA. For example, I’ve seen a few plans – of rather larger employers – where their index fund options have annual expense ratios that are 0.01% to 0.02% per year lower than what can be bought in an IRA.
But keep in mind that level of fee difference could be splitting hairs. As an example, if you have $1,000,000 invested, a difference of 0.02% per year in expense ratio is only $200 per year of fee savings. That may not be enough savings to justify leaving money in your employer plan.
Other fees to keep in mind with employer plans are the various transactional fees. For example, most plans charge a fee of $20-$50 every time you need to take a distribution. On the other hand, IRAs generally don’t charge any fee to distribute money out. As such, once you’re retired and actively taking money out of retirement accounts, it will almost certainly be cheaper to be doing so out of an IRA as opposed to out of the employer plan.
Access to professional advice – While some employer retirement plans may come with access to financial advisors through the plan, many do not. If you want to work with a financial advisor, particularly one who manages investments as part of their offering, they will almost certainly require you to roll money out of your employer plan into an IRA so they can then manage the money within the IRA.
Outside financial advisors (i.e. those who aren’t made available to participants within the employer plan) generally aren’t able to directly manage the assets within employer plans. However, they can directly manage assets held within an IRA.
Therefore, if you’re looking for an independent financial advisor to help you manage your retirement investments, you will likely need to roll money out of your employer plan into an IRA.
Keep in mind the advisor’s services will have a fee associated with it. As such, you will then be paying more in fees within the IRA than you would have if you left money in the employer plan. But, you are getting something for it; the advice that comes from a financial advisor.
With that said, be sure to carefully vet any potential advisor you are considering hiring, and make sure they will provide the services you actually want and expect from them. And be sure you’re aware of how much you’ll be paying them, IN DOLLARS, not just percentages.
In my opinion, many financial advisors overcharge for providing bare minimum services; particularly those who just focus on managing investments as opposed to offering broader financial planning.
Like I mentioned before, many employer plans have a plenty good enough roster of investments to choose from. Therefore, it may not be worth rolling money out of your plan just to pay an advisor the typical 1% of assets under management to basically recreate what you already have access to within your employer plan. On a $1,000,000 account, 1% per year equates to $10,000 per year in fees.
Maybe you’d be better off just working with an hourly advisor who can give you some guidance on what investments to use within your employer plan, as opposed to rolling money out to an IRA.
Better control over tax withholdings – When it comes time to eventually distribute money out of employer retirement plans, most have a mandatory 20% federal tax withholding that has to be made. This doesn’t apply to money rolled over directly to another plan or to an IRA; it just applies to outright distributions (such as when you’re distributing money out to pay for day-to-day living expenses).
For example, if you distribute $100,000 from your 401(k), $20,000 will be withheld for federal taxes and sent straightaway to the US Department of Treasury on your behalf. That means you’ll only get a net $80,000 of cash from the distribution.
To be fair, most people have to pay tax on their pre-tax retirement account distributions. However, withholding 20% is quite possibly more than necessary for many folks. Which means they will end up getting that extra withholding refunded to them at tax return time; it’s not like the money is lost.
However, it would be better if you had more control over how much tax you withhold from your distributions. For example, maybe your federal tax rate is only 10%. In that case, having to withhold 20% from an employer plan distribution would be overkill.
In an IRA, you can withhold as much, or as little, federal tax as you want. That means you have more flexibility and control in managing how and when you have taxes withheld.
An IRA can also have tax withholding benefits at the state level, too. Specifically, the Federal TSP doesn’t allow for ANY state tax withholdings. If you live in a state that taxes pre-tax retirement account distributions, it would be ideal if you could have some amount of state income tax withheld from your TSP distributions. An IRA would allow that, whereas keeping money in, and taking distributions from, your TSP would not.
More withdrawal options – Many employer retirement plans limit the frequency of withdrawals you can take from the plan after you retire. At one extreme, I’ve seen plans that only allow ONE withdrawal in the person’s life. That basically means they either need to keep all of the money in the plan, or take it all out; there is no in between.
Most plans aren’t that restrictive, but may limit the number of withdrawals per year, per quarter, etc. For some folks, those restrictions may be manageable. But for others, they may want or need more flexibility and discretion with how often they take distributions.
With an IRA, there are no restrictions on the number or size of distributions that can be taken out of the account.
Less Required Minimum Distributions (“RMDs”) to manage – Both employer retirement plans and IRAs are subject to RMDs such that when the account holder is of a certain age, the IRS mandatorily requires the person to distribute - and pay tax on - a minimum amount each year.
Each employer plan that’s not a SEP IRA or SIMPLE IRA has its own RMD that must be met. For example, assume you have a TSP account from when you briefly worked for the federal government 20 years ago, and you also have two 401(k) plans from the last two jobs you had, both of which were at private employers.
When you turn RMD age (either 73 or 75, depending on your year of birth), you will need to separately calculate and take an RMD from each of those three plans.
Conversely, if you roll them all into an IRA, you’ll then just have one RMD to have to calculate and take, making the management of RMDs much easier.
Even if you have multiple IRAs – including SEP IRAs and SIMPLE IRAs – you can aggregate their RMD requirements together and take one big fat RMD out of just one of the accounts to collectively satisfy the combined RMD requirements across all of the accounts. You can’t do that with non-IRA employer plans; they each need to have their own RMD requirement independent satisfied.
Ability to do Qualified Charitable Distributions (“QCDs”) – If you’re charitably inclined, this may be a big one for you.
If you’re at least 70 ½ years old, the IRS will let you do a distribution of pre-tax money from your IRA directly to a qualified charitable organization, place of worship, etc. This is called a Qualified Charitable Distribution, or QCD. And it can only be done from IRAs (or inherited IRAs); not employer plans.
Donating via QCD instead of giving cash from your bank account is arguably the most tax-efficient way to make cash donations, and here’s why:
If you take a normal distribution out of your IRA, that will increase your gross income. However, assume you then you turn around and donate that cash to a charity. Assuming the donation is large enough to itemize as a deduction on your tax return, the donation will reduce your taxable income thereby offsetting the increase in gross income caused by the distribution. All said and done, the tax impact appears to be zero because the itemized deduction of the donation reduces your income by the amount of the IRA distribution.
However, the distribution nonetheless increases your gross income, and gross income is what’s used to determine whether other hidden or knock-on taxes come into play.
For example, income-based Medicare premium surcharges are keyed off of your gross income, not your taxable income. The Net Investment Income Tax is also keyed off your gross income, not your taxable income.
As such, one of the main benefits of QCDs is that the money donated this way does NOT show up in your gross income in the first place.
But, at tax return time, you’ll need to remember you did QCDs during the year and manually account for it on your return. When you receive the 1099-R from your IRA custodian at the end of the year, it won’t make any mention of how much of your total distribution(s) was QCD vs normal outright distribution. The burden is on you to remember you did QCDs and manually reflect it on your tax return. If you don’t, the QCD will flow into your tax return as if it was a normal fully taxable distribution.
The other main benefit of QCDs is that they can take the place of RMDs. If you’re charitably inclined, of RMD age and don’t especially need the money from the RMDs, you can do QCDs to use up all or some of those RMDs, thus not having to realize them as taxable.
For example, assume you have $50,000 of RMDs this year. Perhaps you do a QCD for $30,000 and then take the remaining $20,000 as a normal distribution. This way, only $20,000 of taxable income will actually show up on your tax return (again assuming you properly account for the QCD on your return). The $30,000 of QCDs will go right to the charity and stay off your tax return.
The amount of QCD you can do in any given year is rather large. For 2024, it’s $105,000 per person. Which means a married couple could do up to $210,000 of QCDs in 2024.
The annual QCD limit is indexed for inflation and will increase each year going forward.
So, if you’re charitably inclined and over 70 ½, rolling money from your employer plans to an IRA is almost certainly going to be the most tax-efficient way for you to meet your charitable desires.
Less financial clutter – This benefit is probably of the least tangible value compared to the other benefits in this list. But it’s valuable nonetheless.
Many folks in retirement seek to minimize their financial lives, thus making it easier for them to keep track of and manage their money. By having less accounts and less financial institutions to deal with, there will be less online logins to remember, less accounts from which year-end tax documents will need to be received, etc.
Streamlining your financial life into less accounts and institutions also means it will be easier for your executor/executrix to administer your estate when you eventually pass.
Rolling employer retirement plans into a single IRA and/or Roth IRA can greatly declutter your financial life.
Alright, now for the other side of the equation…
POTENTIAL CONS OR DRAWBACKS of rolling money out of your employer plan to an IRA (or Roth IRA):
May lose the ability to take early distributions without penalty – When taking distributions out of an IRA, there will typically be a 10% early-withdrawal penalty on the amount distributed if you’re not at least 59 ½ years old at the time of the distribution. There are some exceptions to this but, generally speaking, assume the 10% penalty will apply when distributing money out of your IRA prior to 59 ½.
With employer plans, there are often slightly relaxed rules around distributions prior to age 59 ½.
For example, with 457 plans, there is no such early withdrawal penalty at all, regardless how old you are when you distribute money from them.
401(k) plans have something often referred to as the “rule of 55.” This says that if you separate from service from the employer belying the 401(k) in the year you turn 55 or older, you can take penalty-free distributions from that particular 401(k) prior to 59 ½ without the 10% penalty.
The federal Thrift Savings Plan also has the rule of 55. As do 403(b) plans.
Furthermore, public safety employees of a state, or political subdivision of a state, can take penalty-free withdrawals from their employer’s plan if they separate from service from that employer in the year they turn 50 or older. As such, it can be considered the rule of 50 (not 55) for employees such as federal law enforcement officers, air traffic controllers, customs and border protection officers, federal firefighters, etc.
Once money is rolled from any one of the aforementioned employer plans into an IRA, it immediately losses these special early withdrawal penalty exceptions and the person will need to wait until 59 ½ to distribute money without the 10% penalty (unless another exception applies).
May lose the ability to cleanly do backdoor Roth IRA contributions – This one is rather technical and won’t apply to most people. But it’s nonetheless something to be aware of, in case it comes into play for you.
If your income is too high such that it makes you ineligible to directly contribute money to a Roth IRA, there is a workaround way to still contribute to a Roth IRA, but through the metaphorical “backdoor.”
This process involves first making an after-tax (i.e. non-deductible) contribution to a traditional IRA. Regardless how high your income is, you’re allowed to make an after-tax contribution to an IRA, assuming you have earned income.
The second step in the backdoor process is to then immediately do a Roth conversion of the money you just contributed from your traditional IRA. And just like that, the money you contributed to your traditional IRA ends up as if it was contributed to your Roth IRA.
In a perfectly executed backdoor Roth IRA contribution, you wouldn’t have any money in any IRAs, other than the after-tax contribution you just made in the first step. And then when you convert that, you don’t pay taxes on it, because you already paid tax on the money before you contributed it.
The process gets muddy when you DO have other money in any IRAs. Specifically, if you have any pre-tax money in any IRAs. If you do, there will then be proration of taxation on the conversion. In other words, some of the amount converted will be treated as converting a portion of the pre-tax money in your IRA(s), and the rest of it will be treated as converting the already-taxed contribution you made. The latter will be tax-free when converted, the former will be taxable.
Notice I said it’s IRA balances that come into play in this proration process. Balances in non-IRA employer plans don’t get factored into the proration process when converting money from your IRA to your Roth IRA.
As such, if you’re looking to do backdoor Roth IRA contributions and you don’t currently have any other money in your IRA(s), rolling money out of your non-IRA employer plan to your IRA will throw a bit of a wrench into the taxation of the backdoor process.
Lose the ability to continue to delay RMDs from that plan (if you’re still working) – When you have an employer plan like a 401(k) and are still working for that employer, the IRS doesn’t require you take RMDs from that account, even if you are of RMD age.
For example, assume you have an IRA and a 401(k) from the employer at which you’re still currently employed. And further assume you’re 75. You are of RMD age and will need to take annual RMDs from your IRA. However, so long as you continue working for that employer, you will not need to take RMDs from that 401(k).
However, it should be mentioned that the IRS doesn’t require you to take RMDs from that 401(k), but your employer technically still can. While I think it’s rare, it’s nonetheless possible that your employer might actually require you to start RMDs from your 401(k) at your normal RMD age, even if you’re still working.
Lose the ability to take loans against the money – Employer plans often offer the ability for participants to take loans against their accounts. For example, 401(k) plans generally allow you to take a loan of up to $50,000 out of your 401(k) balance.
Taking loans out of retirement savings often isn’t ideal, as it means the money borrowed out is no longer invested and (hopefully) growing. Additionally, 401(k) loans need to be paid back within five years. Also, payments typically have to be made quarterly, with interest. And if you leave that employer before paying the loan back, loan repayment is typically accelerated such that repayment is then required essentially immediately.
Nonetheless, for people who don’t have better options for accessing money, taking a loan from an employer plan could be a solution.
On the other hand, the IRS prohibits loans from IRAs. As such, taking a loan from an IRA is simply not possible.
May lose the ability to take advantage of Net Unrealized Appreciation (“NUA”) of employer stock – If you work for an employer in which you own company stock within your 401(k), you may benefit from taking advantage of something called Net Unrealized Appreciation, or “NUA.”
Normally, when you distribute any money from a pre-tax retirement account like a 401(k) or IRA, the dollar amount of the withdrawal will be fully taxable as ordinary income.
However, if you have company stock within your 401(k), you may be able to pay less tax on those shares.
NUA can get tricky and fully explaining it is beyond the scope of this article. But I’ll at least summarize it to try to get the general point across.
Assume you buy or acquire company stock in your 401(k) for $10,000. And then further assume that stock grows in value to $100,000 within your 401(k). The $90,000 of appreciation is called Net Unrealized Appreciation, or NUA. If you sell the shares within your 401(k) to then either distribute the cash or roll it to an IRA where you’ll eventually sell it and distribute the cash, you will pay ordinary income tax on all $100,000.
However, if you instead transfer (not sell) those shares from your 401(k) to a regular brokerage account, that $90,000 of NUA can then instead be taxed at reduced long-term capital gains tax rates whenever you sell the shares in the brokerage account.
It should be noted that the $10,000 of original share acquisition cost will be taxed as ordinary income in the year of the NUA distribution to the brokerage. Additionally, if you’re under 59 ½, it will also be subject to the 10% early withdrawal penalty.
If you instead transfer the shares to an IRA via a rollover, you then lose the ability to take advantage of the reduced tax on the $90,000 of NUA. Like I said before, every dollar distributed from that IRA will instead be taxed as ordinary income.
There is A LOT more to NUA than this. But the gist is that if you have highly appreciated company stock within your 401(k), you want to carefully consider whether rolling everything to an IRA is better than doing the NUA distribution to a brokerage account.
Potentially lose access to a stable value or managed income portfolio investment option – Many employer plans offer something typically called a “stable value” or “managed income portfolio” investment option. In the TSP, this would be the G Fund.
Such investments are principal protected and therefore can never lose value. And they pay some positive rate of interest. In that sense, they’re functionally kind of like high yield savings accounts, or money market mutual funds.
Currently, as of the writing of this article in August 2024, the interest rates paid on such investment options isn’t better than other principal protected investments you can buy yourself in IRAs. Things such as Treasury Bills, money market mutual funds, CDs and even some savings accounts are currently paying higher levels of interest than most stable value funds or managed income portfolios in employer plans.
However, during the pandemic when interest rates were basically at zero and you could MAYBE get up to 0.50% on principal protected things like Treasury Bills, CDs, etc., most stable value funds or managed income portfolios were paying roughly 2%, give or take a bit.
I know 2% interest doesn’t currently sound like a lot. But, a few years ago, getting 2% interest with no risk of loss was super juicy.
Therefore, one reason to consider keeping at least some money in your employer plan is to take advantage of any principal protected interest-bearing investment options it may provide. While such investments may not be good now (compared to what you can get in an IRA), they could prove valuable again if/when interest rates drop substantially.
Potentially less creditor protection – When you have money in an employer plan, it often has unlimited protection against bankruptcy and general creditors. This is definitely the case with 401(k) plans, except for solo or individual 401(k) plans. I believe the federal TSP also similarly has full bankruptcy and general creditor protection, as do 403(b) plans, but only if they are covered by the Employee Retirement Income Security Act of 1974, or “ERISA.” I’m frankly not sure about 457 or 401(a) plans.
Before moving forward, notice I said most plans are fully protected from both bankruptcy and general creditors. It’s important to understand this difference before we move forward. DISCLAIMER: I am not a lawyer, nor do I play one in monthly newsletters. Do not consider anything here to be legal advice. Before acting on any of this information, discuss this topic and your potential concerns with legal counsel well versed in retirement account legal protections. Thanks!
Bankruptcy protection would come into play if/when you become bankrupt, or insolvent. This basically means you have more debts than you can pay off. For example, assume you have only a few hundred dollars in the bank and your only other financial asset is the money in your 401(k). Further assume you have $50k of car loans outstanding, and you lose your job such that you have no income and can’t repay your car loans. You could file for bankruptcy and go to bankruptcy court. Because your 401(k) is protected from bankruptcy, the court can’t make you tap into your 401(k) to pay off the car loans. You can ultimately have the loans discharged as you’re not otherwise able to pay them off, and your 401(k) would remain intact.
This may not be an ideal way to play this, as the bankruptcy would do some real damage to your credit score for a handful of years. As such, it might actually be more in your interest to tap your 401(k) to pay off the car loans instead of filing for bankruptcy. But, nonetheless, your 401(k) is untouchable by your bankruptcy creditors, such as the auto loan lenders in this case.
The other protection is general creditor protection. An example of this would be someone slips and falls on your sidewalk because there was a snow storm yesterday and you haven’t yet cleaned off your sidewalk and it iced over.
In this case, the person who fell may experience physical harm such that they can no longer work and/or they will have a lot of medical bills as a result of their injuries. They can sue you for negligence (for not cleaning your sidewalk) and causing them the injuries and lost wages. They then can come after all of your assets that AREN’T protected from general creditors.
In this example, assume you own your home, you have $50k in bank accounts and you have $300k in a brokerage account. The person can make claims against you on those assets. If the judge in the case rules that you caused the person $500k in damages (just to pick a number for sake of this example), you’d be at risk of having to give them the money from your bank account, brokerage account and potentially they could put a lien on your house.
However, if you have money in a 401(k), that’s completely off limits to the person. They can still sue you for more than you have (in which case I think you’d have to pay them over time as you earn income), but they can’t make you tap your 401(k) because it has full general creditor protection.
For people who have a lot of assets that would be subject to creditor attachment (e.g. real estate, bank accounts, brokerage accounts, physical possessions), it’s a good idea to buy an umbrella insurance policy, which can provide coverage in a liability lawsuit like this. Umbrella insurance typically comes in coverage denominations of a million dollars. Which means you could buy one million, two million, three million, etc. of creditor liability coverage this way. And umbrella insurance is generally rather inexpensive for the amount of coverage it provides.
Anyway, back to the rollover discussion…
So, with 401(k) plans and most other employer retirement plans, the money in them has unlimited bankruptcy and general creditor protection. But what happens when you roll money out to an IRA or Roth IRA???
The unlimited bankruptcy protection that the funds had in the employer plan ports over and stays applicable within the IRA. Additionally, money you separately contributed to your IRA over your life (i.e. separate from what’s rolled in from employer plans) has it’s own level of bankruptcy protection. For 2024, each person has about $1.5 million of bankruptcy protection across all of their IRAs, for money they directly contributed, plus growth thereon.
As such, for the vast majority of people, bankruptcy protection of IRAs really isn’t an issue. That’s because money rolled out from employer plans is already protected. And then any money separately contributed has it’s own rather large limit of $1.5 million (which most peoples’ IRA balances – outside of rollovers – won’t exceed that much). It should also be noted that this $1.5 million level is indexed for inflation and increases each year.
Now that we’ve established that bankruptcy protection of rollovers is a non-issue, let’s focus on general creditor protection. This could potentially be an issue, depending what state you’re in.
Unlike the federally mandated unlimited bankruptcy protection of employer plans that ports over to IRAs and when rolled over, the general creditor protection of employer plans does NOT port over to IRAs when rolled over. Instead, each state dictates the level of general creditor protection of IRAs (and Roth IRAs), whether the money in them was rolled over from an employer plan, or directly contributed.
Thankfully, most states fully protect IRAs and Roth IRAs from general creditors. Here is a summary of each state’s protection, and citations of the relevant sections of the state statutes that govern the protection, or lack thereof.
As you can see in the link, for the vast majority of states, it says “Yes” to both “IRA Exempt” and “Roth IRA Exempt.” However, the devil is in the details in some cases.
As an example, for Michigan, it says IRAs and Roth IRAs are exempt from creditor claims. However, there is a quirk in the way the statute is written such that only one IRA or Roth IRA is protected and exempt. If you have three different IRAs and you live in Michigan, only one of them is actually protected from creditors; the other two are not. In this case, the easy fix would be to consolidate your three IRAs into one! But, if you have both an IRA and Roth IRA, it appears only one of those would be protected and the other wouldn’t. As such, state creditor protection isn’t necessarily foolproof.
With this said, should you personally worry about the potentially lower general creditor protection of rolling an employer plan out to an IRA or Roth IRA? It depends. For the vast majority of folks, especially those in states with full protection of IRAs and Roth IRAs, it’s a non-issue. Even if the state creditor protection isn’t as robust as the federal protection granted to employer plans, I still don’t know that the creditor protection point should stop you from taking advantage of the other benefits of doing a rollover.
If you’re a slumlord renting out run down apartments where there’s a high risk that someone is going to get hurt in one of your dilapidated properties, yes, you should probably worry about the creditor protection issue (or stop being a slumlord!)
But, for the vast majority of people who don’t have above average risk of getting sued for something, I don’t feel this point should be of major concern. Plus, you can get yourself a few million dollars of umbrella insurance coverage to help be the first line of defense in case you do get sued.
Well, that’s it. I know this was rather lengthy, but my goal was to try to make the most comprehensive and thoroughly explained list of rollover pros and cons as possible. If you’re still reading this far, thank you! And I hope you got a lot out of this!