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Call it a mistake waiting to happen. Every year millions of workers who retire or switch jobs must figure out what to do with money in their 401(k) plan. Should they leave the money with their former employer? Should they cash out? Should they transfer the money to their new employer’s plan? Should they roll over the money into an IRA?
Big money may be at stake in the answer to those questions. And lots of people still make costly mistakes even when they answer the questions correctly.
Consider: Some 7.5 million Americans took about $440 billion in distributions from their 401(k) plans in 2004, according to Brightworks Partners research. Of the 7.5 million, 6.25 million were job changers and 1.25 million retired. Of the 7.5 million, 55% had 401(k) balances greater than $5,000.
Where did the money go? About 45% — representing some $200 billion — rolled their 401(k) into an IRA, while 32% left their money in their former employer’s plan, 20% withdrew the money and paid the taxes due on that distribution, 9% transferred their money to a retirement plan at their new employer and 6% purchased an annuity or arranged to have the money paid in installments over a period of time.
To the untrained eye, all that 401(k) money sloshed to and fro problem free. Nothing could be further from the truth.
According to Mercer HR Services, many workers get off the retirement-savings track when faced with the what-to-do-with-my 401(k) question. For one, many workers — especially those who had 401(k) balances of less than $5,000 — took taxable cash distributions. In fact, more than 40% of distributions from a 401(k) plan were taken in cash, according to the Federal Reserve Board’s 2004 Survey of Consumer Finances.
Taxable cash distributions
A new law — the automatic IRA rollover law — was put in place in 2005 to address what the U.S. Department of Labor called leakage, small-balance 401(k) owners cashing in their nest eggs. With that law, workers who have between $1,000 and $5,000 in their 401(k) and leave their employer will have their money automatically rolled over to an IRA unless they choose otherwise. And to some degree, that new law has helped reduce the problem of cash-outs, David Wray, president of the Profit Sharing/401(k) Council (PSCA).
According to a Centier Bank study of small-balance plans published in a PSCA newsletter, only 2.7% of workers cashed out of their 401(k) plans over a 17-month period following the enactment of the automatic IRA rollover law. What’s more, 12% of workers had their 401(k) automatically transferred into what’s officially called a safe harbor IRA. That’s an IRA in which the worker’s money is invested in funds designed to preserve principal and provide a reasonable rate of return. (One problem with this model is that the safe harbor IRA may or may not sync up with the investor’s investment goals so it’s imperative that workers examine whether the investments in the safe harbor IRA make sense or not.)
The bigger problem with small balance transfers, however, is this. James Boyd of Centier Bank noted that there’s a large percentage of what the industry calls “no-contacts,” that is, missing or nonresponsive 401(k) participants. Some 80% of small-balance participants who left their employer were labeled as “no contacts” in the Centier Bank study. And in the extreme, funds in those plans could be escheated by a state as unclaimed property. And that’s just another form of leakage, according to Boyd.
Paperwork problems
Even workers who want to roll over their 401(k) plan to an IRA can fly off the savings track, according Mercer HR Services. Indeed, the process to transfer those assets is downright difficult and onerous.
For instance, about one-third of the forms required to complete the transfer are not completed correctly. In other cases, the forms are lost in transit. Workers often spend countless days if not weeks completing, correcting and tracking down paperwork and calling multiple plan sponsors. Mercer estimates that the traditional process of requesting and completing an IRA rollover could take up to two to three weeks.
So what can be done to head off those problems? First, make sure an IRA rollover is the best option. “Before deciding to roll over 401(k) assets to an IRA, people should make sure that they are not missing out on other benefits by rolling over the assets,” Denise Appleby of Appleby Retirement Consulting said in an e-mail.
Appleby said there are two cases when a worker might choose something other than a rollover. If a person has employer stock in a qualified plan account that has been highly appreciated since they were first added to the account, Appleby said it may be more beneficial to have those stocks credited to a regular savings account instead of an IRA, as that person would then be able to apply capital gains treatment to the earnings. “Rolling these stocks to an IRA means that the individual would pay ordinary income tax on any distribution of the earnings from the traditional IRA, instead of the capital gains rate,” she said.
In another case, Appleby said if the balance in the qualified plan includes after-tax amounts, the person should consider whether it would be more beneficial to have that amount credited to a regular account, instead of being rolled over to an IRA.
“Rolling over employer stocks and after-tax amounts are not necessarily poor choices, and may even be suitable for some individuals,” she said. “However, many individuals’ roll over these amounts unknowingly and attempt to reverse the rollover, but then it’s too late.’
Once the decision to do an IRA rollover as been made, Ed Slott, author of “Your Complete Retirement Planning Road Map,” suggests that the “best way to get this done right is to engage the people that have the most to gain from having you as their customer.”
Slott said workers leaving a company should contact either the IRA custodian or the financial adviser who will be investing the IRA funds early in the process. “They will make sure the rollover is done properly,” he said. “They will be gaining a new customer so they will be more than happy to handle all the paperwork.”
Slott said workers should never leave it to the plan sponsor or plan provider to help with the paperwork. “They generally do not have competent help and just really want to get rid of you,” he wrote in an e-mail. “The people at the plan don’t work for you. They work for the plan so they could really care less if the transfer goes as you would have liked.”
Appleby agrees. “Before completing the rollover request, the individual should have it, and the account statement, reviewed by a financial adviser who is proficient in the area of rollovers and IRA management, to ensure that the proper elections are made on the forms, and to help ensure that the options selected are the ones more suitable for the individual’s financial profile,” she said.
No matter who does the rollover, make sure it is done as a trustee-to-trustee transfer (a direct rollover) where the funds go directly from the plan to the IRA, Slott said. “If the funds are withdrawn and then rolled over to the IRA then a 20% withholding tax will be taken from the funds and it may be tough to find the money to make up the 20% to complete the rollover,” he said. “With a direct rollover, 100% of your company plan funds go to your IRA with no tax withholding.”
What’s more, with a direct rollover, the worker doesn’t have to worry about depositing the retirement money into an IRA within the 60-day grace period. If the taxpayer doesn’t roll the retirement money into an IRA within 60 days, the taxpayer will pay a penalty on the distribution and possibly more taxes.
After requesting the withdrawal/rollover
After requesting the withdrawal, Appleby said the person should take the following steps:
- Find out from the plan administrator when the transaction will be processed. Some plan administrators process distributions during certain periods, like the end of every quarter or only after a certain number of days have passed since the end of employment.
- Check back with the plan administrator about a week before the due date to make sure it is on track.
- Check with the receiving financial institution, not only to make sure the funds were received but that they were credited to the right account. There are countless instances where assets are erroneously credited to regular accounts instead of IRAs. Often, the error is not detected until months or even years later, creating an accounting nightmare for everyone involved.
- Also, check to make sure that amounts that are credited to IRAs are processed properly. For instance, check to make sure it was processed as a rollover contribution, which is reported on IRS Form 5498 and not as a nonreportable transfer.
Even workers who do IRA rollovers get off retirement-savings track
Appleby said most qualified plans liquidate the plan assets and complete the rollover in cash. This means that the money will likely sit in cash or a low-interest money-market fund in the IRA, she said.
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In some cases, the money sits in cash because of inertia; investors have a proclivity to do nothing. In other cases, the money sits in cash because investors don’t know how to re-allocate their funds or find funds that were similar to the ones in their 401(k) plan.
“Individuals should make the money work for them by having it invested in assets that can produce higher returns,” said Appleby. And they should consider hiring an adviser to help with that process, say both Appleby and Slott.
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