This past week I decided to convert my 401(k) into a rollover IRA and I’d like to share with you why. Given I no longer have earned income, I can no longer contribute to my 401(k). The market is fully valued in my opinion which means I see a greater risk of a pullback during the summer than continued gains. Even though my 401(k) has 40 or so mutual fund choices provided across various sectors, countries, and asset classes it isn’t enough for what I want to do.
THE BENEFITS OF ROLLING OVER TO AN IRA
1) More selection. 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.
2) Lower costs. The only costs you have when buying a stock is the transaction cost. I get 100 free trades for the first year of my rollover, so my transaction costs will likely be nothing for one year. ETF costs are usually 0.1% or less, which is why the ETF industry has grown tremendously at the expense of the actively managed mutual fund industry.
I ran my 401(k) through Personal Capital’s 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) Less trading restrictions. 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 miniscule 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.
4) Less tax headaches. 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. 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 35 and have a rollover IRA that is worth roughly $400,000. 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). You aren’t going to be making more money and paying a higher tax rate in retirement than when you are working.
THE NEGATIVES OF ROLLING OVER INTO AN IRA
1) May blow yourself up. 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 think Apple ($420), Baidu ($83), and Sina ($47) are buys here for various reasons which I can elaborate on in a later post. Please don’t make stock trades based on what I think by the way. Do your own research. All three stocks have been dogs for over 12 months and will likely continue to be dogs until some catalyst arises. I’m happy to buy now and wait for such catalysts at current valuations. Only time will tell whether I’ll be right and we can all look back on this post in six months and laugh. Single stock risk is much higher than market risk.
My 401(k) would probably only fluctuate +/- 15% for a 12 month period based on how I’ve constructed my portfolio. With Apple, Baidu, and Sina I could easily see +/- 30% swings to $280,000 to hopefully $520,000+. Please note that I’m just using these three stocks as examples for the present time and ideas are constantly changing. Watch out for that swine + bird flu in China!
2) Might be more stressful. 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 Personal Capital 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 very 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. My pre-tax retirement portfolios have always been seen as funny money where the government could easily taketh away.
3) Retail prices. 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.
4) Have to make an effort. 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 it’s the year 2013 and 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. You can also open an E*TRADE Rollover IRA with this link if you’re looking for other options. I’ve used E*TRADE for over 10 years and they have a massive selection of investment options.
ROLLOVER THAT 401(k) 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. You will surprise yourself by how quickly your contributions add up over time!
WEALTH BUILDING RECOMMENDATION:
Stay On Top Of Your Money: If you want to build wealth, you need to know where your money is going. Consider signing up for Personal Capital, 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 ~$440,000 portfolio.
I’ve used Personal Capital for the past year and they are the best free tool on the web to help you manage your money. They are based here in San Francisco and after meeting with several of their employees, I’m excited about all their upcoming new product offerings to help us build wealth. It only takes a minute to sign up.
For 2015, the maximum 401k contribution is now $18,000. Happy savings!