Know Before You Roll - Options for an Old 401(k)
By Kristi Bickham, retirement management solutions platform director, 1st Global
Back in April, Money Magazine publsihed an article  that suggested many plan providers aren’t offering enough information to plan participants when it comes to rolling over their 401(k) balances. According to an investigation by the U.S. Government Accountability Office (GAO), “retirement plan providers are offering misleading or even false information about 401(k) rollovers that can cost participants thousands of dollars in additional fees.”
The article portends that providers are enticing participants into their proprietary solutions that will make the providers more money. While I won't argue that there may be providers who may purposely mislead participants into rolling assets into their solution, we must remember that in most cases, providers (record keepers, custodians, third-party administrators) are not fiduciaries under the Employee Retirement Income Security Act of 1974 (ERISA). Providers can talk about rollovers and promote their IRA options all day long. There aren’t restrictions when it comes to them promoting their own services, so the GAO’s findings aren’t surprising. It’s a different story, however, for those of us who consult with plan sponsors, who are considered a fiduciary under ERISA, whether directly named as such or determined a “functional fiduciary” by the actions we might take in support of a plan. As an ERISA fiduciary, we must act solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them. An ERISA fiduciary must manage all plan duties with prudence. Prudence does not just mean "with care" or "best intentions." Prudence means … with investigative process from which all plan decisions will be based.
As advisors to ERISA plans, we are in a position of trust. If we apply the rule of prudence to participant education on rollovers, we have a responsibility under ERISA to discuss all available options with plan participants to ensure they have enough investigative information from which their decisions may be based. This means covering all of the options available for distribution or rollover within their plan's governing document, describing all of the fees associated with each of those options including the difference in investment expenses from one option to the next. We must outline and ensure understanding of any penalties or tax implications for rollover or distribution decisions< including the pros and cons of each alternative. We must disclose any conflicts of interest such as any incentive we may have, financial or otherwise, to route a participant to an IRA solution that we will manage. We must also ensure that any education we give to participants or any information we provide on rollover solutions that we may manage, is done outside of plan education activities – one-on-one – and that participants understand such guidance is not provided as a plan service. Educating participants is a paramount responsibility of what we do in ERISA consulting. Quite a lot of money is left in plans simply because participants haven’t been properly educated as to their options. Knowing how to educate with prudence and to the exclusive purpose of providing benefit to the participant can be a valuable differentiator in the market space. Participants need our help.
So what ARE the options available to someone who may have an old 401(k) plan balance? Following are the four most common options and some pros and cons of each. Always guide the participant to contact their former employer to inquire as to the options available in their plan document, before they proceed with their "benchmarking" so to speak, of their distribution and rollover options. They should consider their time horizon - how soon might they need the money after they roll it over? Know before you roll!
Option 1) Leave the Money in the Old Plan
Pros: Participants may choose to leave their money in an old plan because they prefer the investment options in the prior plan. Leaving money in an old plan may make sense if the participant is happy with the investment performance and if the expenses are lower compared to that in a new employer's plan. Participants may also use the former plan as a "holding tank" if they have changed employers but aren't quite eligible yet to roll their balance into the new plan or, are working for a company that doesn't offer a plan or if they are still looking for work. Leaving the balance in the plan allows the participant to retain tax deferred status of the assets. Costs should always be considered when reviewing options for asset distribution. If the fees associated with the new plan are higher, it might make sense to leave the money in the old plan or consider a different option.
Cons: One of the drawbacks to leaving assets in an old plan is that once you leave the company providing that plan, you can no longer contribute to it. Most plans also have provisions that allow the plan to force out balances for terminated participants. If a lower balance is left in an old plan, participants could find themselves in this situation. Another consideration for participants is that they will likely still incur plan fees after leaving the company. Balances still have to be updated. Statements still have to be generated. The plan sponsor and vendor still have a responsibility so long as the balance remains in the plan.
Option 2) Roll the Money into a New Employer Plan
Pros: Many participants choose to transfer their assets into a new plan in order to consolidate, continue contributions and take advantage of the power of compounding. The deferral amounts that can be contributed to a 401(k) and deducted from taxes are considerably higher than that of an IRA. In some cases, there may also be an employer match that further grows the participant balance.
Cons: Know the options before you roll! Some plans will not allow participants to roll balances into the plan until they are eligible to participate. Others may only allow rollovers for those actively participating in the plan. Participants need to be aware of plan rules for acceptance of rollovers. The new plan may also have less favorable distribution options compared to the old plan. The plan document will dictate how and when money can be distributed.
Option 3) Roll the Money into an IRA
Pros: As the Money Magazine article outlines, the financial industry spends a great deal of time marketing IRAs because they are considered an administratively easy solution with the most flexibility in investment options. Assets transferred to an IRA will retain their tax deferred status until distributed. IRA fees may also be lower than they would be in an old or new 401(k) plan, so an IRA may be the preferred choice by the participant.
Cons: As mentioned above, the amount a participant can contribute to an IRA is considerably less than what can be contributed to a 401(k). For example, 2013 employee contribution limits are only $5,500 for a traditional IRA versus $17,500 for a 401(k) (the limits are $6,500 for an IRA and $23,000 for a 401(k) if the participant is 50 or older). As well, an unsophisticated investor may struggle with the level of investment flexibility or may not adequately understand the options. Once again, costs must be considered – administrative, investment expense, trading, etc. The fees may make each option more or less attractive to the participant. IRAs also do not offer any ability to take a loan from the balance, whereas some, but not all, 401(k)s allow loans. Know before you roll!
Option 4) Cash Out
Pros: When a participant cashes out, he has money in his pocket and cash to spend.
Cons: Lump or partial sum distributions equal money lost! The plan sponsor is required, though there are certain exceptions, to automatically withhold 20 percent of the taxable balance for federal taxes when a cash (direct) distribution is requested. While participants have 60 days from the date of a distribution to roll their balance over to a new plan or IRA without penalty, any portion that is not rolled over becomes taxable as ordinary income. As well, individuals under the age of 59 1/2 will pay an additional 10 percent early distribution penalty. For example, if you are under 59 1/2, have a $10,000 balance in your 401(k), and you request a cash distribution, subtract $2,000 (20 percent withholding) up front, so your cash withdrawal is $8,000. Keep in mind that when you file your federal income tax return, you must also pay $1,000 (10 percent early distribution penalty) and, for, the sake of this example, if you are in a 15 percent tax bracket, you will owe $1,500 in federal income tax. $2,000 of this $2,500 will be offset by the tax that was withheld when you made the initial withdrawal. In the end, the $10,000 in this example is actually only $7,500 ($10,000 less $1,500 federal income tax and $1,000 penalty). You incur a 25% loss on your withdrawal. We see this option used frequently, but I don't know any advisor who would recommend it unless the plan participant needs cash and has no other alternative.
Participants should always refer to the governing plan document before making a decision as to what to do with their money in terms of a distribution or rollover.
As a stated or functional fiduciary of a plan under ERISA, advisors must be very careful when discussing these options. Make sure you are providing guidance and education, not offering advice. Discuss the availability of options versus the advisability of options. Provide adequate documentation to demonstrate prudence – a key element for ERISA plans. Work with the plan sponsor to educate participants and help them fulfill their responsibility as a fiduciary. Participant education is an effort that should be shared by all. We should encourage participants to be informed consumers of investment products and solutions. It’s quite staggering sometimes that we will clip coupons and price check a bag of rice or bargain shop for clothes, but we pay little attention to the cost impact of financial decisions that can have a most dramatic impact on our lives.
Many participants have no access to a financial advisor or accountant and will receive little to no financial guidance outside of their 401(k). For most, the only financial education they will receive is through their 401(k) provider. We have an incredible opportunity to educate and empower a nation of participants, simply by being skilled stewards for our retirement plan clients.
Kristi Bickham is director of the Retirement Management Solutions (RMS) Platform at 1st Global. She assists financial advisors in the field with the growth and success of their financial practices by providing support with client meetings and retirement planning strategies and solutions.
1st Global Capital Corp. is a member of FINRA and SIPC and is headquartered at 12750 Merit Drive, Suite 1200, in Dallas, Texas 75251; (214) 294-5000. Additional information about 1st Global is available at www.1stGlobal.com.