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Teach Your 401(k) New Tricks

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Most of us change jobs every few years. When we do, we often need to decide what to do with our 401(k) money -- move it into our new employer's 401(k) plan, roll it over into an IRA, or just leave it alone in the care of our previous employer. Despite the possible drawbacks and alternatives, an IRA rollover can sometimes be your smartest choice.

Just to play devil's advocate…
Whatever you do, don't simply cash out your 401(k) when you leave a job. You'll lose a fat chunk of your accumulated savings to taxes right off the bat. Whatever short-term windfall the remaining cash provides will pale in comparison to the amount that money could yield in retirement if you leave it alone to compound over time.

Rolling your old 401(k) money into your new company's plan can make sense, if the plan offers appealing investment choices and low fees. It can also be a good move if your balance is very low, since you may not be able to diversify just $1,000 or $2,000 well in other accounts.

In addition, a 401(k) plan can better shield your assets from creditor in pursuit. A recent Wall Street Journal article quoted IRA consultant Ed Slott: "While federal law shields the assets in 401(k) plans from a variety of claims, it only safeguards IRA assets in cases involving bankruptcies." Some states add protections for IRAs, but many don't.

Another benefit of staying in a 401(k) plan is that investors 55 or older can often withdraw funds from a 401(k) penalty-free, while IRAs force owners to wait until age 59 1/2 to avoid a 10% penalty for taking money out early.

Protection from creditors and penalty-free withdrawals are worth considering. But for the many of us who don't expect to have creditors dogging us, or who don't anticipate needing to borrow from our accounts, they're ultimately irrelevant.

Why an IRA might work for you
In many, if not most, cases, it's best to go ahead and roll over your money into an IRA. You can do so into a traditional IRA rather effortlessly. Establishing a Roth IRA with that money is tougher, since you'll have to pay taxes on the rollover amount -- but given that Roth withdrawals are designed to ultimately be tax-free, paying the taxes can be well worth it.

A chief benefit of the IRA is its flexibility. Whereas 401(k)s limit your investment options considerably, you can park all kinds of things in your IRA -- such as individual stocks, bonds, and even, in some cases, real estate.

And even when the fees in your current or prospective 401(k) plan are low, chances are that the fees you'll pay for investments in your IRA will be as low or lower. When purchased in an individual brokerage account, many index funds and exchange-traded funds sport expense ratios (annual fees) of just 0.10% or less. It's hard to beat that anywhere.

What kinds of investments should you choose?
Be strategic with your IRA. It's a great place to store hefty dividend payers, the better to shield them from taxes. Those dividends can become a rather reliable source of growth and income. Tobacco giant Altria (NYSE: MO  ) recently paid a 5.6% yield, while utility specialist National Grid (NYSE: NGG  ) had a trailing yield of 5.5%. Those rates far surpass most rates on savings, and you can expect stock-price appreciation on top of them over the long haul.

Real estate investment trusts, or REITs, also deserve consideration. Since they pay out 90% or more of their earnings in dividends, they can especially benefit from the tax benefits of IRAs. Chimera Investment (NYSE: CIM  ) recently yielded more than 14%!

Hypergrowth
Fast-growing stocks also make great candidates for an IRA, especially a Roth IRA. Our Motley Fool Rule Breakers service studies such companies exclusively. Among others, the service recommends Universal Display (Nasdaq: PANL  ) , with an average annual revenue growth rate of 20% over the past five years, and expected annual earnings growth of 40% over the coming five years. Universal Display supplies organic light emitting diode (OLED) technologies and materials to the flat-panel display industry.

To appreciate how a Roth IRA can bolster high-performing investments, look at Freeport McMoRan Copper and Gold (NYSE: FCX  ) . In addition to a bright potential future fueled by growing global demand for minerals, it's enjoyed years of strong growth. Over the last decade, its stock averaged 23.8% annual growth, enough to turn a $10,000 investment into more than $84,000. If that were taxed at 15%, you'd fork over more than $11,000. In a Roth IRA, though, you'd keep that sum.

ETFs rule
Powerful exchange-traded funds make another great IRA holding. The best of them give you instant exposure to wide swaths of the domestic or global economy, all for a low fee. The Vanguard MSCI Emerging Markets  (NYSE: VWO  ) ETF, for example, invests you in small and large companies in Africa, Asia, and Latin America. The Vanguard Total Stock Market (NYSE: VTI  ) is a compelling investment because it parks you in the entire stock market, setting you up to outperform thousands of managed mutual funds.

If you're close to retirement, holding bonds in your IRA can make sense, shielding you from hefty tax rates -- especially if you're in a high income bracket. You can achieve that easily with bond ETFs such as the iShares Barclays Aggregate Bond Index.

Lots of choices
Just as your 401(k) offered you a range of mutual funds, you can invest in funds in your IRA, too, with a much greater variety of choices. Sure, some might charge higher fees than ETFs and other funds -- but sometimes a higher fee can accompany much greater performance. And when a fund engages in frequent trading, that turnover can result in higher taxes -- which your handy IRA can defer or avoid altogether.

In short, if you don't want to roll over your 401(k) into your new employer's plan, look into moving it into an IRA. You may end up very glad you did.

Looking for promising investments? Grab this special free report: "Six Stocks to Watch From David and Tom Gardner."

Longtime Fool contributor Selena Maranjian owns shares of National Grid. Universal Display is a Motley Fool Rule Breakers choice. National Grid is a Motley Fool Income Investor selection. The Fool owns shares of Altria and Vanguard MSCI Emerging Markets. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (1) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 16, 2011, at 12:27 PM, sufferingproust wrote:

    This website is becoming a joke. You post the following.

    Hypergrowth

    Fast-growing stocks also make great candidates for an IRA, especially a Roth IRA. Our Motley Fool Rule Breakers service studies such companies exclusively. Among others, the service recommends Universal Display (Nasdaq: PANL ) , with an average annual revenue growth rate of 20% over the past five years, and expected annual earnings growth of 40% over the coming five years. Universal Display supplies organic light emitting diode (OLED) technologies and materials to the flat-panel display industry.

    However in another motley fool article that is not a blog, its an actual employee states its of the FOOLS opinion that PANL is going under.

    So lets get this straight, you tell people to consider PANL in a retirement account yet 5 days before tell people the company is going to collapse. Now if these were BLOGS on the motley fool that would be one thing but this is quite another. Tom your company is starting to look naive and its already lost its professionalism. Embarrassing to say the least.

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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