Should You Immediately Roll Your Old 401?

There is a common theme in my world I wish people would stop automatically doing. It is immediately rolling an old 401k to an IRA when you switch jobs. The key here is this is done without thinking of some of the longer-term consequences regarding financial planning, wealth management and also lifetime tax bills. Again, here is a video if that is easier.

Rolling your old 401k into your IRA is something pushed heavily in my world. It is an example of Money in Motion. When I started a million years ago at Merrill Lynch we were taught to chase money, as it could then be managed by me and I could charge fees. While this always benefits the advisor and firms like Merrill Lynch, it isn’t always the best move for the client. 

I will mention the most important consideration when one of my physician clients is dealing with something like this – will it mess up Backdoor Roths? Having money in an IRA does not prevent Backdoor Roths, but they can confuse the matter a bit. Let me explain. 

The average physician has income high enough where they cannot directly contribute to a Roth IRA. Contributions are made via the Backdoor Roth strategy. Having Roth dollars is important to provide some “never-to-be-taxed-again” funds in retirement. However, the presence of an IRA with pre-tax/tax-deferred dollars makes the Backdoor Roth process a bit more complicated. 

The short version is when you do the Backdoor Roth Uncle Sam wants to know what percentage of IRA dollars has never been taxed. This percentage then is applied to the amount you just did via Backdoor and brings it back into your income. Here is a simple example. Say you have $95,000 in an IRA that is funded via an old 401k rollover. You now want to contribute $5,000 to your Roth via the Backdoor Roth. Uncle Sam combines the total amount of $100,000 and says you have not paid taxes on 95% of that so that portion of your Roth is now brought back into your taxes for the year of conversion.

One other thing to think about before making this automatic rollover from your old 401k to an IRA includes the fees you would be paying.  Advisors used to argue you would pay a lower fee and have better investment choices by rolling your 401k to them. Fees on 401k plans have come down quite a bit and their investment menus have improved so this argument does not hold the weight it once did. Plus, many more employers allow you to now transfer 401k balances from old jobs. Basically, talk to your new employer and find out if they allow you to roll your old 401k into the new plan and confirm the total fees. 

By simply taking a bit of time to look at the big picture you can truly decide whether it makes sense to roll your old 401k into an IRA. However, if your advisor’s reaction without missing a beat is to immediately roll your old 401k to them you need to rethink if the advice is for your benefit or them.