401(k) to IRA? A rollover dilemma

NEW YORK (Money) -- Question: I retired in October 2005 and left my 401(k) account with my former employer. Right now I've got my money divided among a large-company stock fund, a small-cap fund, an international fund and an emerging market fund. The account has been doing well and I'm fairly happy with its performance.

My question is should I leave my 401(k) account with my ex-employer for the long haul or should I roll it over to an IRA account at a fund company? - Shabbir Shad, Dallas, Texas

Answer: The answer to your question depends on a number of factors, ranging from when you need to tap the money in your 401(k) to how pleased you are with the line up of investment choices in your plan to whether you find it easy to get the information you need to monitor your account and access it even though you're no longer an employee.

In general, I think people are better off rolling their 401(k) money into an IRA when leaving a former employer. For one thing, you can open an IRA rollover at virtually any mutual fund or brokerage firm. That gives you access to a lot more investment options than you get in a 401(k) lineup.

Not that I think you should be spreading your money among dozens of funds.

You shouldn't. But by being able to pick and choose among the various investment firms out there, you can be more selective about the funds you do choose. Which means you can find ones that have solid long-term track records, a history of treating their shareholders well and, most importantly, that charge below-average fees.

(For a list of such funds that covers all the fund categories and investment styles you need, check out the Money 70, Money Magazine's roster of recommended funds.)

Until recently, it was also clearly better to move your money to an IRA if you named someone other than your spouse as the beneficiary of your account. That's because an IRA allows someone who's not your spouse to stretch out the payments from the IRA over his or her life expectancy - the same as a spouse can - thus enjoying many years of tax-deferred gains. Only a spouse had that option when inheriting a 401(k), however. A non-spouse beneficiary had to take the money within five years of the 401(k) owner's death.

But thanks to last year's Pension Protection Act that's changed - sort of. As of this year, a non-spouse beneficiary may be able to transfer an inherited 401(k) into an IRA and stretch out withdrawals over his or lifetime. I say "may be able to" because a recent IRS notice providing guidance on this issue says that 401(k)s and similar plans are not required to allow rollovers to an inherited IRA for a non-spouse. It's basically at the plan's discretion.

And even if the plan does allow this option, there are some bureaucratic details you best not mess up. You must set up a special "inherited" IRA to accept the 401(k) rollover, and you must do it through a trustee-to-trustee transfer - that is, the 401(k) administrator must send it directly to the IRA custodian. If you transfer the money into an existing IRA or if you take a check for the 401(k) proceeds, you'll owe taxes on the money.

As a practical matter, then, if you want someone other than your spouse to inherit the money in your 401(k) and you want to be absolutely sure that person has the option of stretching out withdrawals, it's probably simpler just to move your money from the 401(k) to an IRA rollover account where the stretch option is more definite.

In short, another reason not to stick with the 401(k).

That said, however, there may be one compelling rationale for someone who's retired or very near retirement to leave a 401(k) with a former employer, at least for little while. If you've left your old company and you're 55 or older, you can pull money from your 401(k) account and pay only income tax on the withdrawal. With an IRA, by contrast, if you're under 59 1/2, you'll not only pay income tax on any withdrawals, but a 10 percent penalty as well.

So if you think you might need to tap your old 401(k) for living expenses between the ages of 55 and 59 1/2, it might make sense to leave it with your ex-employer where you can get to it without paying that 10 percent penalty.

Once you hit 59 1/2, however, this advantage disappears. So at that point, you may want to transfer whatever money you have left to an IRA rollover account - and consider investing in solid low-cost funds like those you'll find in the Money 70.

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The right way to tap into your 401(k)

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