Sturti | E+ | Getty ImagesThe problem primarily impacts job switchers, particularly those with small accounts, who often cash out their accounts instead of moving them. They lose out on their savings and future earnings from that money. According to the Employee Benefit Research Institute, about 40% of workers who leave a job withdraw their 401(k) plans each year. The group’s most recent data shows that these “leakages” totaled $92.4 billion in 2015. Research suggests that much of this loss is due to the convenience of cashing out rather than going through the process of transferring the money to a new 401(k) or an individual retirement account. The estimated impact of workers cashing out their accounts on the 401(k) system is significant, with the Employee Benefit Research Institute estimating that it would have nearly $2 trillion more over a 40-year period. Recent legislative changes, such as Secure 2.0, and partnerships among some of the largest 401(k) administrators are working to reduce this friction and address existing leaks, according to experts. Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute, stated that this movement has gained momentum in recent years and believes that retaining the money in these accounts will lead to greater retirement savings for more people.
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The U.S. has various measures in place to keep money within the tax-preferred retirement system. For instance, individuals who withdraw money before the age of 59½ generally face a 10% tax penalty in addition to regular income tax. Furthermore, there are limited options for workers to access their 401(k) savings before retirement, such as loans or hardship withdrawals, which are also considered sources of leakage. However, switching jobs is another point of access, and policymakers are particularly concerned about this. When workers change jobs, they have the option to receive a check, net of taxes and penalties, among other choices. According to an analysis by the U.S. Labor Department, on average, baby boomers changed jobs about 13 times from ages 18 to 56, with about half of these job changes occurring before the age of 25. A recent study indicated that 41.4% of employees withdraw some of their 401(k) savings when leaving a job, and 85% of those individuals cash out their entire balance. The authors of the study, John Lynch, Yanwen Wang, and Muxin Zhai, highlighted that it is not necessarily a logical decision to cash out these savings upon leaving a job.
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However, it’s not entirely the workers’ fault. By law, employers can cash out the small balances of former employees who leave their 401(k) accounts. They can do so without the workers’ consent and send them a check. Before 2001, employers were able to do this for accounts with a balance of $5,000 or less. However, the Economic Growth and Tax Relief Reconciliation Act, passed in 2001, prohibited employers from cashing out balances ranging from $1,000 to $5,000. Instead, businesses wanting to remove these balances from their company 401(k) plans must transfer the funds to an IRA in the respective workers’ names. Secure 2.0 raised the upper limit to $7,000 starting in 2024. While this IRA solution retains more money in the retirement system, experts argue that it is not a perfect fix. When the assets are transferred, they are typically held in cash-like investments such as money market funds, earning minimal interest and being eroded by fees. Additionally, many investors eventually cash out these IRAs.
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In November 2023, six major administrators of 401(k)-type plans – Alight Solutions, Empower, Fidelity Investments, Principal, TIAA, and Vanguard Group – initiated an “auto portability” program to further reduce leakage. In simple terms, small balances of $7,000 or less would automatically follow their owners to their new jobs, unless they choose otherwise. This mechanism aims to prevent workers’ savings from being cashed out or rolled into an IRA and potentially forgotten. This concept leverages the same passive approach as other popular 401(k) features such as automatic enrollment, capitalizing on workers’ tendency to take no action. Auto portability constitutes a large exchange mechanism within the 401(k) industry, according to Spencer Williams, founder of Retirement Clearinghouse. He emphasized that auto portability is expected to reconnect about 3 million people a year with 401(k) accounts they left behind upon job change, with the most significant benefits accruing to young workers, low earners, minorities, and women. Williams stated that administrators also stand to gain from this, as it keeps more money within the 401(k) ecosystem, potentially boosting their profits.
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Secure 2.0 also provided legal backing to the auto portability concept by granting a “safe harbor” for automatic asset transfers, according to experts. Furthermore, the law directed the U.S. Labor Department to establish a “lost and found” for forgotten retirement accounts by the end of 2024. This online registry will help workers locate plan benefits they may be entitled to and identify who to contact to access them. The Technology Modernization Fund, a government program, announced a nearly $3.5 million investment with the Labor Department in November to assist in building this database. In the meantime, workers who suspect they may have left behind an account have several options to recover it, including checking old records, contacting former employers or unions, or seeking assistance from the Employee Benefits Security Administration advisors.
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