Should I Convert My 401(k) Into A Rollover IRA?

When I retired in 2012, I decided to convert my 401(k) into a rollover IRA. Given I no longer have earned income as an early retiree, I can no longer contribute to my company 401(k). For those of you who are transitioning to a new job, rolling over your 401k is a good idea.

Even though my 401(k) had 40 or so mutual fund choices provided across various sectors, countries, and asset classes, it wasn't enough for what I wanted to do. Many people who rollover their 401(k) feel the same way. With an IRA, you've got plenty more investment options.

The Benefits Of Converting Your 401(k) Into A Rollover IRA

Overall, I think it's wise to to rollover your 401(k) into an IRA after you leave your old employer. Here are the reasons why.

1) More selection of investments with a rollover IRA.

I always want to be fully invested in my 401(k) because I've got other portions of my net worth in risk-free investments such as CDs. I treat my 401(k) like my own little hedge fund or mutual fund and so should you. You wouldn't invest in a mutual fund that decides to go 80% cash because the reason why you are investing in a mutual fund is for equity or bond exposure. Equity mutual funds also have restrictions to how much cash they can hold e.g. usually 5% maximum.

My 401(k) is restricted to mutual funds only. I cannot buy specific stocks or ETFs nor can I short any securities as a hedge. To get short the markets I either have to go to cash or buy a bond fund, which admittedly turned out quite well (Read: The Proper Asset Allocation Of Stocks And Bonds By Age and see VUSUX).

In essence, I wanted to move from being a macro fund to a hege fund who picked specific stocks with the flexibility to hedge. Names such as Apple, Baidu, and Sina are on my list. A rollover IRA offers much more selection.

2) Lower costs with a rollover IRA versus a 401(k).

Today, there are no more transaction costs to buying and selling stocks. With a rollover IRA, you can buy low-cost index funds and ETFs. But with a 401(k), you are forced to invest in whatever your 401(k) plan offers. And if your 401(k) plan mostly offers high-cost actively run funds, then you have to pay more fees.

I ran my 401(k) through Empower's free 401(k) Fee Analyzer and discovered my existing portfolio at the time would have cost me $1,700+ a year. That's a ridiculous sum of money to be losing.

I can easily construct my own portfolio of specific stocks and ETFs for $0 fees or probably less than $100 a year on a ~$400,000 portfolio. That's a no brainer in my mind. If you haven't run your 401(k) through the fee analyzer, I strongly suggest you do, especially since it costs nothing.

3) Fewer trading restrictions with a rollover IRA.

My 401(k) and practically all 401(k)s have trading restrictions for the number of times you can rebalance a year. My old 401(k) restricted me to 13 rebalances a year until I would be locked out from rebalancing for a full three months after the limit was hit. Even if I wanted to move a minuscule 1% from one fund to another fund, that would count as a rebalance.

One probably shouldn't conduct more than four major rebalances a year, but if you really like to optimize your portfolio by sticking to some specific percentage balances, 401(k) rebalancing restrictions are quite onerous. With my rollover IRA I can trade as much as I want provided I have the cash balance. Read: How Often Should I Rebalance My 401(k) A Year for more thoughts on the topic.

With a rollover IRA, you can trade all you want. Just don't become a habitual day trader. You most likely won't be able to outperform the market over the long term.

4) Less tax headaches due to no tax filing.

If you like to trade, you will have to reconcile your trades (report your cost basis) every single year to the IRS. About 10 years ago I completely forgot to report the cost basis for around $2 million in trades for some reason. The IRS therefore thought I made $2 million in trading profits and sent me a tax bill for over $500,000!

In reality, I probably made only around $30,000 in profits as the $2 million was simply the total value of transactions. I sent in my individual costs by security and they exonerated me from the bill a couple months later.

With the rollover IRA, you can literally make a million trades and you won't have to input a million reconciliations because the IRS only taxes you during the time of withdrawal on the total amount. This is something many people do not realize so feel free to ask questions in the comments section if you are unclear. With a taxable brokerage account, any trades you make in the year will need tax reconciling.

The IRS doesn't see all the buys and sells in your 401(k) either, but you are restricted from the amount of trades you can make. For those with a tendency to trade, a rollover IRA is much better than a 401(k).

5) Penalty-free early withdrawals.

There is an interesting rule called the 72(t) distribution which allows for early withdrawal before the age of 59.5. The catch is that once you elect to withdraw early you must continue to withdraw for five years or until you turn 59.5, whichever is longer. Your principal withdrawal is going to be taxed as ordinary income taxes so there is no free lunch.

The 72(t) distribution is great for folks who have retired early and have a sizable IRA they would like to tap. Let's use me for example.

I retired at 34 and have a rollover IRA that was worth roughly $400,000 (now $1 million). I'm moving from the top income tax bracket of 39.6% to the 25% tax bracket thank goodness. What I can do is comfortably withdraw $10,000 a year in principal for 25 years until I'm 60 since some of the $400,000 is due to gains. Taking out $250,000 at a 25% tax bracket vs. a 39.6% tax bracket is roughly $37,000 less in taxes I've got to pay!

The 72(t) distribution is another reason why I'm against a ROTH IRA (pay taxes up front) if you're above the 24% marginal federal income tax bracket. You aren't going to be making more money and paying a higher tax rate in retirement than when you are working.

6) Borrow funds penalty- and tax-free.

When you rollover your 401(k) to a IRA or another 401(k) plan, you can utilize the 60-day rollover rule to borrow money tax- and penalty-free. The catch is you have to deposit back the funds within 60 days to prevent paying a penalty and taxes.

The 60-day rollover rule is a less widely known “loophole” that enables retirement savers to tap their funds for short-term needs.

The Negatives Of A Rollover IRA

Now let's talk about all the negatives of rolling over a 401(k) into an IRA.

1) May blow yourself up by trading too much in an IRA.

With a wider selection of securities to choose from, you will be tempted to invest in things you wouldn't normally be able to buy in your 401(k). I'm constantly going after higher risk, growth stocks like Tesla, Amazon, Apple, and Sina. Given trading is now free, you may be tempted to day trade your portfolio, which will likely result in underperformance or losses.

My 401(k) would probably only fluctuate +/- 15% for a 12 month period based on how I've constructed my portfolio. With growth stocks I could easily see +/- 30% swings to $280,000 to $520,000+.

Most professional money managers can't outperform their respective indices. Therefore, your chances are slim too. You may really hurt your overall performance as an active investor.

Below is a chart showing how the average investor severely underperforms other asset classes over a 20-year period.

2) Might be more stressful managing a Roth IRA.

When you've got all the power, all the glory and all the pain is on you. I used to check my 401(k) linked to my free Empower account along with other portfolios maybe once or twice a week to make sure everything is on track.

Now I check my rollover IRA on a daily basis because I've got much higher risk with single stock investments. Speak to any hedge fund analyst or manager and they will tell you they are always on because of what's going on in the Asian markets at night and the European market closing during our early mornings.

You can easily reduce your stress by having a more diversified rollover IRA portfolio that mimics exactly what you would have bought in a 401(k). But I'm a balls to the wall type of guy who bets big if I believe strongly in something.

Having 25 positions at 4% each is very uninteresting. Give me five positions at 20% each or even three positions at 33% each and it's game on! One of my biggest regrets at age 22 was not investing more in a stock that returned 50X in one year. At least I did invest several thousand dollars which I parlayed into my first rental property.

We can talk about portfolio theory and the efficient frontier in another post. I'm risk loving with my rollover IRA because I don't need the money and I can't touch the money without penalty until age 59.5.

3) Retail prices and higher fees.

Your 401(k) plan will probably have institutional prices for their mutual fund offerings which are lower than retail prices. Think of lower pricing like buying at Costco or group health insurance. Retail investors don't have bulk pricing power and therefore will pay more for the same fund in an IRA most of the time.

The PIMCO Total Bond fund has an expense ratio of 0.46% for institutional investors and a 1.6% expense ratio for class C retail investors. Hence, if you like your mutual fund selections in your 401(k) then it doesn't make sense to leave your 401(k) and buy the same mutual funds in your IRA.

401(k) plans are a business. And you're the client if you have one. You have to invest wisely to lower your fees.

4) Have to make an effort to roll over your 401(k) into an IRA.

Rolling over your 401(k) into an IRA takes action. Most people I know are either scared of investing or too lazy to stay on top of their investments. I didn't roll over my 401(k) for one full year because I was happy with just making macro bets and didn't want to bother trying to figure out how to rollover the portfolio.

Luckily the internet has made things as easy as cake. I logged onto my Fidelity account and clicked the “rollover” option, answered some questions and viola! My rollover IRA was available the very next day. I think all of the major financial firms that have 401(k) plans also have rollover IRA options. It's much easier than you think. Just give them a call or click around on the homepage.

Also, I don't think doing a Roth IRA conversion is worth the time. Yes, it's good to diversify your retirement funds to minimize taxes and required minimum distributions. But unless you're doing the Roth IRA conversion when you're unemployed, the taxes you pay will likely be a wash or more.

Roll Over Your 401(k) Into A Rollover IRA If You Can

I recommend everybody who has lost a job or who is transitioning to a new job to rollover their 401(k) into an IRA due to an increased selection of investments, lower expenses, and more flexibility.

Just be honest with yourself in understanding your own risk tolerance and gambling tendencies. Make no mistake that the stock market is the world's largest casino. There's a reason why vernacular such as “making a bet on XYZ stock” exists. Nobody knows the future, but we can all make educated investment decisions.

Please continue to do your best and max out your 401(k)s and IRAs in the meantime. The contribution limit for your 401(k) and IRA is $22,500 and $6,500, respectively. You will surprise yourself by how quickly your contributions add up over time!

Related: A Roth IRA Conversion Is Probably A Waste OF Time And Money

Diversify Your Investments In Private Real Estate

In addition to investing in your 401(k), I recommend diversifying your investments in private real estate. Real estate is my favorite asset class to build wealth because it is less volatile, produces income, shows positive historical returns, and provides utility.

Today, you no longer have to own physical real estate to earn passive income and returns. Instead, you can invest in private real estate across the country.

Best Private Real Estate Investing Platforms

Fundrise: A way for all investors to diversify into real estate through private funds with just $10. Fundrise has been around since 2012 and manages over $3.2 billion for 350,000+ investors. 

The real estate platform invests primarily in residential and industrial properties in the Sunbelt, where valuations are cheaper and yields are higher. The spreading out of America is a long-term demographic trend. For most people, investing in a diversified fund is the way to go. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. These cities also have higher growth potential due to job growth and demographic trends. 

If you are a real estate enthusiast with more time, you can build your own diversified real estate portfolio with CrowdStreet. However, before investing in each deal, make sure to do extensive due diligence on each sponsor. Understanding each sponsor's track record and experience is vital.

I've invested $953,000 in real estate crowdfunding so far. My goal is to diversify my expensive SF real estate holdings and earn more 100% passive income. I plan to continue dollar-cost investing into private real estate for the next decade.

Both platforms are long-time sponsors of Financial Samurai and Financial Samurai is an investor in Fundrise.

Wealth Manage Recommendation

If you want to build wealth, you need to know where your money is going. Sign up for Empower, a free online wealth management tool which keeps track of your income and expenses, tracks your net worth, and provides portfolio analysis tools to see if you are properly positioned and paying too much in fees.

I personally am saving over $1,700 in annual portfolio fees I had no idea I was paying after running my 401(k) through their Fee Analyzer tool!  My rollover IRA now costs under $450 in fees annual based on a ~$450,000 portfolio.

Another excellent tool they just rolled out in 2016 is their Retirement Planning Calculator. Unlike other retirement calculators, Empower's takes your real data from your linked accounts and runs thousands of algorithms through a Monte Carlo Simulation to produce the most realistic future financial scenarios possible. You can recalculate with multiple variables.

Special Promo: Get A Free Financial Checkup

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If you have over $250,000 in investable assets, don't miss this opportunity. Schedule a free appointment with an Empower financial advisor here. There is no obligation to use their services after. 

A year after leaving finance, I had two free consultations with an Empower financial advisor that revealed a major blind spot. I had 52% of my portfolio sitting in cash, thinking I needed to invest like a conservative 65-year-old. The advisor reminded me that at 35, I still had many financial opportunities ahead. Within three months, I invested 80% of that cash and used the rest for a down payment on a fixer-upper—both decisions paid off well.

About the Author:

Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.

In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $400,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.

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