A provision in President Biden's new legislation aims to keep workers from cashing out their 401(k) when they move from one job to another, building on a similar effort launched last year by the private sector.
The legislation paves the way for employer retirement plans to provide automatic portability services, so funds can be transferred seamlessly into a new employer plan unless the worker opts out. It also increases the limit for automatic rollovers from $5,000 to $7,000. That follows a new consortium launched in October by leaders in the 401(k) retirement field with the goal of automating retirement plan rollovers.
Liquidating funds before a certain age is costly with penalties and taxes and can rob vulnerable workers the chance to generate meaningful savings for retirement. But some critics say the moves may be too narrow and don't fully address why people cash out early.
Before the legislation was signed in December, a collaboration of Vanguard, Fidelity Investments, Alight Solutions, and the Retirement Clearinghouse created the Portability Services Network, a nationwide, digital exchange that will automate the process for their sponsor clients and their participants to move 401(k), 401(a), 403(b), and 457 account balances from plan to plan when employees change jobs.
The consortium — expected to go live by the end of March — currently represents around 43.8 million workers across more than 48,000 employer-sponsored retirement plans, based on data published by Pensions & Investments. This new law will help take that to a higher level.
"The legislation has a major, positive impact on the consortium and auto portability," Neal Ringquist, executive vice president at Retirement Clearinghouse, told Yahoo Finance. "This should increase the number of auto portability transactions by 20% when the new law takes effect, ultimately allowing the consortium to reduce the one-time auto portability transaction fee charged to the participant."
The one-time transaction fees charged to the participant are currently $30 for balances over $600, 5% of account balances for balances between $50 and $599, and no charge for balances under $50.
To make a significant impact for future retirees, the practice needs to go big. And the new law's provision should provide that oomph.
“Auto portability’s success depends on scale and the participation of as many of the industry’s record-keepers as possible,” Kevin Barry, president of Fidelity’s workplace investing division, told Yahoo Finance. “We encourage all record-keepers to join the network to deliver the benefits of auto portability to their plan sponsor clients and plan participants.”
Who cashes out?
This is why this new law's provision is critical. In 2021, Fidelity processed 1.1 million mandatory cash-outs for its sponsor clients. Of the 1.1 million, 66% were under $1,000 and sent as checks. And 55% of the 1.1 million were under the age of 35.
One in 3 workers cash out their retirement accounts when leaving jobs, according to research provided by the Women’s Institute for Secure Retirement (WISER). For workers between the ages of 20 and 30, that pops up to 41% or higher, Cindy Hounsell, president, and founder of WISER, told Yahoo Finance.
Job-changing opens the door to take out the money.
Retirement plan leakages primarily come from job separations, followed by home purchases, divorces, large medical expenses, and new college tuition bills, according to an analysis published in the National Tax Journal.
And the younger you are, the greater the odds that you’ll be switching jobs. In 2020, the Department of Labor reported a 10-year median job tenure for workers between the ages of 55 and 64 compared with just under three years for workers between ages 25 and 34.
“We have come together to say, ‘how do we solve this tremendous economic problem that impacts a lot of Americans,” Robert Johnson, founder and chairman of Retirement Clearinghouse, told Yahoo Finance. “This is really aimed at keeping low-wage workers and minorities and women, who are most affected by cash out, in the system.”
The cost of cashing out
Pulling money out of a tax-deferred retirement fund before you’re 59 ½ is costly. The IRS levies a 10% penalty on distributions taken before the account holder is 59 ½. And income taxes are due on the funds that are withdrawn. Ultimately, you lose out on the compounding effects if the balance remained untouched.
For example, If you’re 25 and have $5,000 socked away in your retirement plan, assuming a return of 5%, your account could be worth $38,808 when you retire at your full retirement age of 67. The flip side: If you were to cash out now, you’d pay penalties of $500 to the IRS and taxes of $1,000, leaving you with $3,500.
(If you are curious about how much cashing out can ultimately cost you, you can run the Retirement Clearinghouse’s Cash Out Calculator to show you what even a small balance cashed out can cost you.)
Will it work?
While the new auto-portability provision will certainly help people continue to save for retirement, the scope is limited, according to some industry observers.
“This rollover facilitation won’t help much,” Teresa Ghilarducci, a professor of economics and policy analysis at the New School for Social Research, told Yahoo Finance.
The U.S. ranks low among pension systems, according to the Mercer Global Index, because we allow tax-subsidized retirement money to be tapped before retirement, she said.
“Women and non-white men and women, who are more likely to be low income, are more likely to withdraw retirement savings before retirement and pay a tax penalty because of economic shocks like unemployment, reduced hours, sickness, or a divorce,” Ghilarducci said. “Facilitating money from one plan to the next doesn’t help the people who most likely withdraw and doesn’t address the reasons they withdraw.”
Next year could highlight Ghilarducci’s argument. The Federal Reserve expects the unemployment rate to increase to 4.6% in 2023 from 3.7% this year, meaning many more workers facing a layoff also will face the dilemma of what to do with their retirement savings.
“Facilitating rollovers is completely beside the point, fairly irrelevant to the problem, and won’t move the needle on fixing the retirement problem gauge,” Ghilarducci said. “Fixing pre-retirement withdrawals and improving our system requires preventing pre-retirement withdrawals of tax subsidized retirement savings. Period.”
Kerry is a Senior Reporter and Columnist at Yahoo Money. Follow her on Twitter @kerryhannon