The critical role financial planners play when 401(k) savers switch jobs

Financial advisors with clients who are switching jobs or retiring could fill a gap in information faced by 401(k) savers who may not fully understand the tax consequences of their decisions.

Only about one-third of retirement plan participants surveyed as part of a U.S. Government Accountability Office review of the 401(k) marketplace said they received a "rollover notice" explaining their four options for their savings when leaving the sponsoring employer before they chose how to invest or cash out the assets, according to a report released last month by the independent watchdog agency reporting to Congress. And 82% of the more than 1,000 respondents in the sample of participants told pollsters that they weren't aware of the four main options for distribution of their leftover assets: keeping them in the same plan, rolling them into their new employer's 401(k), opening an individual retirement account or cashing out.

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With a few exceptions available for emergency distributions and certain other circumstances, the latter option carries income taxes, an additional 10% penalty for those younger than 59½ years old and the loss of compounding investment returns on a tax-deferred basis. For advisors, the GAO research offered a lens into why 401(k) rollovers comprise a pivotal area poised for regulatory changes under the Department of Labor's retirement advice rule and how they can guide clients through a crucial decision about their nest eggs when leaving employment from the sponsors of the savers' plans.

At Brooklyn, New York-based Future Perfect Planning, founder Cristina Guglielmetti works with clients to look through "the new menu of options" to check the details of their plan, the fees of the 401(k) and whether the investment funds there are diversified, she said in an interview.

"I make that part of the planning process. 'Oh, you left a job. Here are all the things we need to do' and address the question of, 'Do we roll over or do we not roll over?'" Guglielmetti said. "If everything checks out, I typically have them roll over and consolidate."

Some retirement savers may not be engaging in a thoughtful process like that before they move the assets, though. 

Even though IRS guidelines require the 401(k) plans to send Form 402(f) outlining the possible paths for the leftover assets and the accompanying implications, an estimated 40% of the participants "did not understand the tax consequences of their distribution options," according to the GAO study. At least 53% of the eligible participants with $5,000 or more in their existing plans told pollsters that they didn't know that they could keep their assets in that account rather than transferring them elsewhere. And about 15% got the notice from their plan only after they had already decided what to do with the assets.

"The remaining participants either received the notice at the time they made a decision or did not know when they received the notice," GAO Director of Education, Workforce and Income Security Tranchau "Kris" Nguyen wrote in the report. "As a result, not all eligible participants received information from the notice in time to inform their decisions about their retirement savings, according to GAO's survey. Federal agencies can take steps to facilitate better understanding by participants of their distribution options and corresponding tax consequences, which can also assist spouses when they are informed of their spousal rights."

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The Secure 2.0 Act of 2022 included a provision calling for the GAO to evaluate Form 402(f) as part of many programs in the legislation designed to boost savings and encourage more employers to offer 401(k) plans. Last month's report followed the GAO's comprehensive February list of suggested improvements to 401(k) rules. The watchdog called on the Treasury and Labor departments to take steps to ensure participants get more clear information about their potential options for the assets. Each agency responded to the research with pledges to do so, Nguyen wrote.

"Indecision about what to do with retirement savings as workers change jobs or uncertainty about how to meet necessary requirements in managing accounts can affect retirement security over the course of a worker's career," she wrote in a letter to congressional committees on the findings.

At a scale of 92 million Americans with over $7 trillion in their 401(k) plans, those actions carry major stakes. For those whose employer-sponsored plan uses one of the largest providers in the 401(k) marketplace, Vanguard, those decisions played out roughly the same last year as in prior ones, according to the firm's annual "How America Saves" report. 

Among savers with termination dates in 2023, 94% of the savers' assets "available for distribution were preserved for retirement," and the share of participants "choosing to take cash and presumably spending their savings has remained stable over time," the report said.

"During 2023, more than one-quarter of all Vanguard qualified plan participants could have taken their plan account as a cash distribution because they had separated from service in the current year or prior years," it said. "However, just 18% of participants eligible for a cash distribution took one, while the vast majority (82%) continued to preserve their plan assets for retirement."

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Among 401(k) savers going to a new job, many "get a flurry of things" from their prior plan that they may or may not recognize as the form in question or come in as prospective clients with "orphaned accounts all over the place" that they didn't even know they could move to a different plan, according to Guglielmetti. Unless the clients are retiring, she "almost never" recommends that they roll the leftover 401(k) assets into an IRA because it could set up a "mix of pre- and post-tax money and that's going to get very messy over time," she said. Most of the clients also find it "very difficult to make a deductible contribution" due to the size of the income, and the IRA may preclude opening a post-tax Roth account some day as well, Guglielmetti noted.

In a few cases, she may suggest leaving the assets with the old plan — but that can carry drawbacks as well.

"It's just there and you have to remember to keep it rebalanced along with everything else. You also have to remember to keep the beneficiaries up to date," she said. "Unless there's a really good reason to not consolidate, I usually have everyone consolidate."