Exiting 401(k)s: Facts and Scandal

The IRA and 401(k) industries were upended recently by a report from the Government Accountability Office. Investigators concluded that the process often is a mess when individuals are leaving an employer and need to decide how to handle their 401(k) accounts.

The 401(k) rollover process is inefficient, and financial services firms that administer plans use their positions to heavily market their own IRAs as the preferred option. The GAO found that consumers leaving an employer sometimes were given misleading or false information about their choices and the fees involved.

One problem is that the process of rolling over an account from the 401(k) plan of the old employer to a new employer’s can be difficult. It often requires submitting a lot of paperwork to both plans and long delays. Each employer wants to be sure that no mistakes are being made and that your money isn’t going to the wrong account or being siphoned away in an identify theft scheme. So, they double- and triple-check everything. All that takes time.

Another problem is employers don’t want to be in the business of giving financial advice to their employees, especially those who are leaving. They leave the advice and information-giving to the plan administrators, who usually are financial services firms eager to have the 401(k) accounts rolled over into IRA they administer. The report found that 95% of money contributed to IRAs in 2008 came from rollovers.

An important decision needs to be made when you leave an employer. It doesn’t matter if your leaving is due to retirement, taking a new job, or a layoff. You have to decide what to do with any retirement accounts at the employer you’re departing. The right answer varies from person to person. Your 401(k) and IRAs are among your most valuable assets and your main retirement planning vehicles, if you’re like most people. You need to consider carefully decisions about them, especially what to do when you leave an employer.

In this visit, I give a framework for making decisions about 401(k) accounts that will enhance your financial security.

Many people automatically take a lump sum from their 401(k) plan when leaving an employer, and the financial services industry certainly encourages that action. But that might not be the best move for you. Consider all the factors before deciding.

You generally have these options: leave your money in the 401(k) plan (though some employers discourage this), transfer it to the 401(k) plan of a new employer if it allows this, take the distribution in cash, or rollover the account to an IRA.

First, consider any advantages of keeping the money in the current 401(k) plan.

The 401(k) plans maintained by many small and medium-size employers and even some large employers aren’t good. They have limited investment options that often aren’t among the best funds or asset classes available. The costs can be high. There also might be limits on how often changes can be made in the investments and when money can be taken from the plan.

Some plans, however, especially those at larger employers, can be very good. The employers negotiate low costs and good investment options. For example, you might be able to invest in institutional class funds that have lower expenses than retail mutual funds. Large employers also pick up some or all of the account expenses instead of passing them through to employees.

An employer that takes its 401(k) seriously also seeks out the best funds in each asset category, offers a wide range of asset categories instead of just the basic five or so, and works with outside firms to design target date plans or similar asset allocation funds that are better than the off-the-shelf products at most fund families. You’ll have more investment choices in an IRA, but a well-run 401(k) narrows your choices down to the best ones you’d find yourself and negotiates lower fees.

A 401(k) plan also is likely to have a stable value fund option, which is a good place to hide while earning a decent yield when you want to be out of the markets or are mapping out your future.

A major downside to staying with even a good 401(k) plan is that you can’t consolidate your assets in one account.

You also need to consider the long term. Some plans offer good annuity options when it is time to take retirement distributions or are flexible about setting up distribution schedules or allowing periodic distributions. Others effectively discourage people from maintaining their accounts after retiring by limiting distribution options and making changes cumbersome. Check to see what the plan offers retirees and also what it offers to a beneficiary who inherits the account. Some plans require fast payouts to beneficiaries.

When a 401(k) plan has major drawbacks, your best action is rolling over the 401(k) plan to an IRA or a new employer’s plan. If you are joining a new employer that will accept rollovers, consider the same factors in that plan. You’re required to put new deferrals into the new employer’s 401(k) plan, but you don’t have to roll over your old account to it.

When the new employer’s plan is deficient or you’re not going to a new employer, shop around for an IRA. Don’t assume the IRA offered by the current 401(k) administrator or custodian is best. Consider investment options, fees, and the different ways you can access the account. Take a look at the list of all fees charged for services. Some IRA custodians offer “no-fee IRAs” but then charge a fee every time you want to take money out or make any other transaction.

Once you decide to roll over an employer plan to an IRA or new employer plan, you work isn’t finished. There are different ways to do the rollover, and you need to be sure it’s done right.

One way to roll over an account is to have the plan make out a check to you. After the check is issued, you have 60 days to deposit the account balance in a qualified IRA or employer retirement plan. Fail to make the deposit within 60 days and the distribution is included in your gross income. You’ll owe income taxes, and if you’re under age 59½ a 10% early distribution penalty in addition. 

A lot can go wrong in those 60 days. You could be in an accident, get sick, or lose track of things. Also, you could do everything right only to have the new custodian put the money in the wrong account. All these things and more have happened to people. The IRS allows you to ask for a waiver of the 60-day requirement if you think you have a good excuse. But it’s expensive to have a proper waiver filed, and the IRS doesn’t waive the requirement very often.

Generally, you’ll receive a waiver only if the firm receiving the rollover made a mistake, you were free of fault, and you did everything you could to correct the mistake immediately after you learned or should have learned about it. The IRS even has denied waivers when someone died within the 60-day period.

Another reason not to take the check is that the plan has to withhold 20% for income taxes. You have to come up with that 20% from other sources and deposit it to the new account to make the rollover complete and tax free. You’ll get a refund of the withholding after filing your income tax return for the year.

My advice: Don’t take a check from a retirement plan. You want a trustee-to-trustee transfer. Have the administrator of the plan you’re leaving transfer the money directly to the new IRA or employer plan. You’ll first have to open the new IRA or other account. With an IRA, you complete a form requesting the IRA custodian to have the funds transferred from the old account. The IRA custodian will contact your 401(k) plan administrator and be sure the account is transferred. There’s no 60-day rule with a trustee-to-trustee transfer.

In either case, follow up. Once the account is transferred, be sure it is deposited in an IRA or your new employer’s retirement plan. Sometimes firms make a mistake and deposit transfers into taxable accounts instead of IRAs. You don’t want the hassle of correcting this many months after the fact.

RW July 2013.