Retirement accounts' new safety net

Younger workers who frequently change jobs often undermine their own efforts to build retirement nest eggs by cashing out their qualified retirement account every time they switch employers. New Federal regulations may help them resist their own worst instincts, notes the Financial Planning Association, Denver.

Participants in a defined-contribution retirement plan like a 401(k) or 403(b) have several options when they leave their employer. They can instruct the employer to leave their funds in the plan if the plan allows that, roll the funds over into an individual retirement account or a new employer's plan, or ask for the funds in cash. Some plans mandate that, if the departing employee fails to provide instructions and the account is valued under $5,000, the plan must cash out the account and send a check to the participant.

Under Federal regulations that went into effect March 28, employers whose retirement plan mandates cashing out a small account when it does not receive instructions from the departing employee automatically must roll it directly into a default IRA on behalf of the employee if the account is worth $1,000 to $5,000. For accounts valued under $1,000, the employer still can cash out the account.

Studies show that workers with small accounts frequently take the cash and spend it on everything from vacations to pickups--but not for their retirement savings. A study by Hewitt Associates found that 80% of departing workers who had more than $5,000 either left the money in their former employer's plan or rolled it into an IRA or a new employer's plan. However, 87% of terminated workers with less than $5,000 in their account cashed out. Small accounts are common with workers in low-paying jobs or who change jobs frequently.

Moreover, those who cash in end up with significantly less than the distributed amount. The individual must pay ordinary Federal and possibly state income taxes on the money, and probably an additional 10% early withdrawal penalty if he or she is younger than 59 1/2. Someone in the 15% Federal and five percent state tax bracket, subject to the 10% penalty, would end up with $3,500 on a $5,000 cash-out. In addition, the worker could lose thousands of dollars in future retirement funds because the money no longer grows tax deferred.

COPYRIGHT 2005 Society for the Advancement of Education
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