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So will the funds be liquidated automatically in the transfer, or should we direct the current 401-k custodian to switch the mutual funds into a money market account before we transfer into the IRA?

I've done it both ways this year so I'll give you my experience. The form you fill out with the new broker should have a check box for whether you want the assets liquidated before the account is transfered.

Which to do? Well, liquidating first will save the brokerage fee as you said, but the money will be inaccessible, out of the market, and making money for the custodian for several weeks, while the transfer is in process. Very agravating if the funds in question pick that period to have a big surge.

Also check with the new broker about commissions on trading mutual funds. They may be considerably higher than for stocks.

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