Why you don't want to leave your 401k with your ex-employer.

You've been laid off, down sized, fired or let go.  One of your questions should be "what should I do with my 401k account?"  Leaving your money in your ex-employer's 401k plan is usually the worst choice.  In most cases, you'd be better off rolling it over into a professionally managed IRA.

There are three ways it costs you extra money by staying in that old plan: 1) excessive plan administration fees and 2) expensive mutual fund fees, and 3) a poor investment strategy.  All told, these can cost you thousands of dollars every year, making you work longer before retiring.  Here's a look at each of these in more detail.

Excessive Plan Administration Fees

A 401k plan must meet certain compliance requirements and requires complex record keeping as well as an annual tax filing.  The largest plans require expensive audits by accounting firms.  It therefore costs more to administer a 401k plan than a rollover IRA - and more of these fees are being borne by the participants, not the employer.  In 1988, 87 percent of U.S. employers paid all administrative costs, but today only 25 percent do, according to Hewitt Associates. 

According to a study conducted by Deloitte for the Investment Company Institute in spring 2009, some plans pay an "all-in fee" over 1.72 percent.  (This "all-in" fee includes plan administration and mutual fund costs, but does not include the cost of a poor investment strategy.)

Excessive Mutual Fund Fees

One common practice in the 401k business is "revenue-sharing,"  where mutual fund companies pay an insurance company or broker to be included in their 401k program offered to employers.  These fees are passed on to plan participants either through a 12b-1 fee or an increased management fee.  In many cases a fund used in your 401k will have higher expenses via a different share class than the same fund available in your IRA.  Unfortunately, these fees are sometimes difficult to track down, making you think your plan is cheaper than it really is.

A more subtle, yet common problem is where a mutual fund company is also the plan administrator.  Fidelity Investments is one of the largest 401k providers in the industry.  Rather than choosing the "best of the best" investments available in the entire fund universe from all companies, they load up plans with their own Fidelity brand funds.  This conflict of interest often results in more expensive funds with poorer performance than if Fidelity used another company's funds.

A Poor Investment Strategy

Legendary investor David Booth once said "the important thing about an investment philosophy is that you have one," yet almost every 401k plan offers no investment philosophy whatsoever - they simply give participants a laundry list of mutual funds available, but offer no way to manage the risk of their portfolio, which is the reason why 401k plans are under fire after the 2008 financial meltdown. Having a proven investment strategy is paramount to retirement investing because once those twenty, thirty or forty years have been wasted on a bad strategy, you've lost the advantage of compounding.

Additionally, many plans utilize actively-managed mutual funds, which study after study show are over-priced and under perform.  We wrote about this expensive mistake many investors make in "The Inconvenient Truth About Active Investing."

What does all this mean?

A professionally managed portfolio in your IRA can provide a disciplined investment strategy at the same or lower cost than you're paying for your 401k.  By utilizing portfolio risk management techniques you'll reduce the risk of not retiring when you want to, or having to reduce your standard of living during retirement.  The safest way to transfer money from your 401k to your IRA is via a direct rollover - your plan administrator sends the full amount directly into your IRA with no tax withholding and you'll have no tax consequence or penalty with the IRS.  If you're at risk of being personally sued, it might make sense to leave your money in a 401k plan or some other qualified plan because those assets are protected from lawsuits.  For everyone else, a direct rollover to an IRA makes the most sense.