Protecting Retirement Assets. Recently I’ve run across several articles that say you should not roll over your old 401(k) plan into an IRA, because your funds are more secure from bankruptcy and legal judgments in the 401(k). Most of these articles don’t go into much depth, they just say “your money might not be protected, so you should just keep it in the 401(k).” Often these are written by someone with a vested interest, such as a representative of a company that services 401(k) plans, who would like to encourage investors to leave their money in the plans. Financial advisors who manage IRA’s have an interest also – we can’t manage the funds if they are still in the 401(k) plan, only if you roll them into an IRA.
When you leave an employer, you generally have four options for your 401(k) funds: take a cash distribution, leave the funds in the plan, do a rollover into another employer’s 401(k) plan, or do a rollover into an IRA. The first option, a distribution, creates a taxable event, and can include penalties for early withdrawal if you are under age 59 ½. For these reasons, this option should only be considered after consulting a tax advisor. The option to leave your funds in the current 401(k) or roll them into your new employer’s 401(k) allows you to continue tax-deferred growth, may have good investment options with low fees, and offers some protection from creditors. If you roll into your current employer’s plan, you may also have access to loans if the plan permits them. You aren’t allowed to take a loan against a former employer’s plan. If you do a rollover into an IRA, you lose the option of borrowing against the funds, as loans are not permitted for IRA’s. There may be higher fees than your current plan, and you need to consider any transaction costs as well. Using an IRA allows you to continue tax-deferred growth with a broader range of investment options, including the option to employ an advisor of your choice to manage the account if you wish.
The 401(k) industry uses two scary scenarios to encourage you to keep your funds in your 401(k): bankruptcy and lawsuit. As we’ll discuss below, there is no real difference in bankruptcy protection between IRA’s and 401(k)’s, and there are better ways to protect your funds from a lawsuit. The more likely scenario is that you’ll never be sued or go bankrupt, but your retirement funds may not perform as well as you need them to in order to achieve your goals. The most important thing you can do for your retirement funds is to make sure they are invested in a way that is diversified, efficient and aligned with your own personal goals and risk tolerance. This might best be accomplished by rolling the funds into an IRA.
Let’s consider the specific differences between 401(k) plans and IRA’s: 401(k) plans, as well as 403(b) plans and some other employer-sponsored plans, are covered by the Federal law known as ERISA, the Employee Retirement Income Security Act of 1974. This law gives ERISA assets protection from both creditors (bankruptcy) and judgments (lawsuits). IRA’s are not covered by ERISA, so they are governed by state law. In this sense, it’s true that your retirement funds have different protections from bankruptcy and lawsuits in the employer plan than they would in an IRA. However, different isn’t necessarily better.
The Bankruptcy Abuse and Prevention Act of 2005 gave bankruptcy protection to contributory IRA’s up to $1M. Most importantly, if the funds were rolled in from an employer plan, they are fully protected along with their earnings, so any amounts rolled over from an employer plan are not subject to the $1M cap. Although it’s true that IRA’s are not covered by ERISA, the protection from bankruptcy is exactly the same in the case of rollover funds because of the 2005 Act.
With respect to lawsuits, the protection for IRA’s provided by state law is not as specific as the Federal protection provided by ERISA. Some legal experts believe that judges would follow the guidelines in the bankruptcy rules, and rollover amounts in IRA’s would be protected. There is no case law on the subject, because in practice nobody has succeeded in getting a judgment against an IRA in California.
If you are concerned about protecting your assets from a lawsuit, you should consider purchasing umbrella liability insurance, if you don’t already have it. Umbrella coverage is relatively inexpensive, and is essential for people with significant financial assets. The “umbrella” covers liability in excess of the limits on your homeowners’ and auto policies, which are often $300-500k. In California it’s fairly common to see damage awards that would exceed those limits, so this type of policy is important for your overall asset protection plan. Being allowed to keep your 401(k) would be a small comfort if someone sued you and succeeded in attaching all your other assets.
Now that we’ve addressed the bankruptcy and legal considerations discussed above, there remains the important question of how best to invest and manage your retirement funds. IRA’s have the advantage of providing you with a wider variety of investments, rather than being limited to the funds available in your employer-sponsored plan. You have the option to place your account with an advisor, or to manage it yourself. The rules governing inheritance and distribution of an IRA are uniform, whereas each 401(k) plan has its own rules. Many 401(k) plans charge significant fees when you begin drawing down funds, so they may not be efficient vehicles for taking periodic income when the time comes to take distributions. It’s important to consider all these factors when making the decision whether to roll over your employer-sponsored plan into an IRA.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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Source: This article was written by Margaret (Peggy) Stephan, CFP® – LPL Registered Representative at Retirement Capital Strategies.