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What Should You Do With Your 401(k) When You Retire?

Christine Benz

Given that the 401(k) plan has been around for fewer than 40 years, the generation of people retiring today is the first to have used it as their primary investing savings vehicle. And with that wave will come plenty of questions about what to do with the money. Is rolling it over to an IRA, as is the standard advice for job-changers, the best prescription? Or are there other viable options?

Here's an overview of the key routes you can take with your 401(k) when you retire, as well as the pros and cons of each.

Option 1: Take the Money and Run

Benefits: When you're retired, cashing out of a 401(k) isn't quite as terrible an idea as is an outright withdrawal prior to age 59 1/2. If you're age 59 1/2 or older (or age 55, if you meet certain criteria), you won't owe an early-withdrawal penalty on a withdrawal of 401(k) assets, though you'll still owe ordinary income tax on the distribution.

Disadvantages: The first big negative is that by pulling the assets out of the confines of a tax-sheltered vehicle--an IRA or 401(k), for example--you won't be able to take advantage of tax-deferred compounding (or tax-free compounding, in the case of Roth assets) over the course of your retirement. True, it's not terribly hard to limit ongoing tax costs by investing in a tax-savvy manner within a taxable account. But perhaps the biggest disadvantage to taking a lump sum from a 401(k) is that you'll owe ordinary income tax on the whole kitty--you won't have the opportunity to spread the tax hit over many years.

Option 2: Leave It Be

Benefits: One of the key benefits to leaving your money in some sort of a tax-sheltered vehicle--whether the old 401(k) or an IRA--is that you'll continue to enjoy tax-deferred compounding on your money (or tax-free compounding). This is arguably a particularly big advantage in retirement, as bonds and other income-producing securities take up a large share of your portfolio. That's because you won't owe tax on these investments' income distributions; you'll just owe tax when you yourself begin pulling money out.

It can also make sense to leave the money in your old 401(k) if your former employer offered a gold-plated plan with lots of low-cost options, some of which were exclusive to your company. For example, some plans provide access to ultra-cheap institutional share classes, and you won't find a stable-value fund outside of the confines of a 401(k) plan, either. (Many retirees have told me that their stable-value option is the sole reason they've left assets in their former employer's 401(k) rather than pulling it out.) Provided you're not paying any administrative costs that override the benefits of those exclusive options, sticking with an old 401(k) plan can make sense.

Leaving the money in your former employer's plan can also be the right choice under certain circumstances. For example, people who will need to tap their 401(k) assets prior to age 59 1/2 are also better off leaving the money in the plan rather than rolling it over to an IRA, because they can avoid the penalty on early withdrawals once they hit age 55 and are separated from service during or after the year in which they turned 55. Just be sure to fully assess your portfolio's long-run sustainability before contemplating withdrawals at such an early age. Also note that some 401(k) plans may not allow the age-55 withdrawal option.

In addition, assets in a 401(k) often have better creditor protections than assets in an IRA, though the protections vary by state. Finally, if employer stock consumes a big share of your 401(k), you may save on taxes by leaving the money inside of the plan rather than rolling it over.

Disadvantages: The key disadvantage to leaving the assets behind is that some 401(k) plans are costly and subpar. If that describes your plan, you'll be better off rolling the money over into an IRA, where you'll enjoy full discretion over your investment selection rather than having to stick with a preset menu.

Option 3: Roll It Over

Benefits: As with leaving money behind in a 401(k), rolling money into an IRA enables you to enjoy tax-deferred compounding (or tax-free compounding, in the case of Roth IRA assets) as long as the money remains in the account.

However, a rollover to an IRA can beat holding money in a 401(k), if your 401(k) plan is costly or you've been frustrated by its menu of investing choices. You'll have a wider choice set and won't typically pay administrative expenses to hold your money inside of an IRA. Retired investors may find their 401(k) plans' fixed-income options are particularly limited, whereas IRA investors can pursue a full range of bond options, including high yield, floating rate, and TIPS investments.

Disadvantages: As noted above, IRA assets don't always have the same creditor protections that 401(k) assets do. Moreover, even as some investors might feel stymied by their 401(k)'s sometimes-limited menu of choices, that abbreviated menu can help keep you out of overly risky, narrowly focused options that are readily available for IRA investors.