Leaving a job? What about that 401(k)?

By MarketWatch

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) plans.

Should they leave the money with their former employers? Should they cash out? Should they transfer the money to their new employers' plans? Should they roll over the money into individual retirement accounts?

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: About 7.5 million Americans took about $440 billion in distributions from their 401(k) plans in 2004, according to Brightwork 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)s into IRAs, while 32% left their money in their former employers' plans, 20% withdrew the money and paid the taxes due on those distributions, 9% transferred their money to retirement plans through their new employers, and 6% purchased annuities or arranged to have the money paid in installments over time. (Figures total more than 100% because some participants took more than one of those actions.)

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. 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 401(k) plans were taken in cash, according to the Federal Reserve Board's 2004 Survey of Consumer Finances.

Taxable cash distributions

The automatic IRA rollover law was put in place in 2005 to address what the 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.

According to a Centier Bank study of small-balance plans, only 2.7% of workers cashed out of their 401(k) plans over a 17-month period after 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 not be aligned with the investor's goals, so it's imperative that workers examine whether the investments in the safe-harbor IRA make sense for them.

The bigger problem with small-balance transfers, however, is this: 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 revert to a state as unclaimed property.

Paperwork problems

Even workers who want to roll over their 401(k) plan to an IRA can fly off the savings track. Indeed, the process to transfer those assets can be downright difficult.

For instance, about one-third of the forms required to complete the transfer are not completed correctly, according to Mercer HR Services. 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," says Denise Appleby of Appleby Retirement Consulting.

Appleby says 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, 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.

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