A recent government report highlights how confused 401(k) participants are when they have to decide what to do with their savings after leaving employment.

Tax rules require 401(k) plans (and 403(b) and governmental 457(b) plans) to provide a written notice when participants become entitled to a distribution that can be rolled over. The notice must explain they can do a direct rollover to an IRA or another plan and that a mandatory 20% will be withheld from their payment if they don’t do a direct rollover.

The IRS provides model notices that plans can use to satisfy this notice requirement. Plans typically send the model notice as an attachment to the distribution application form after a participant requests a distribution. However, these model notices have been widely criticized as too complicated for the average plan participant to understand.

The SECURE 2.0 Act required the General Accountability Office (GAO) to issue a report to Congress on the effectiveness of the notices and to make recommendations on how to improve them. The GAO surveyed over 1,000 401(k) participants who, between 2019 and 2022, were eligible to do a rollover to another plan.

Disturbing Results

The survey showed that over 80% of eligible participants did not know that they have four options after leaving an employer:

  1. Keep their funds in the existing plan;
  2. roll over the funds to a new employer’s plan;
  3. roll over the funds to an IRA; or
  4. take a lump sum distribution.

Additionally, over 50% were unaware of the “keeping funds in the plan” option. The GAO said this lack of knowledge was probably because IRS regulations do not require that the notice given out to participants needs to include information about this option.

Moreover, about 40% did not understand three basic tax consequences regarding distribution options:

  1. First, participants can retain the tax-deferred status of their savings by doing a rollover to another retirement account or by leaving funds in the plan.
  2. Second, if they take a lump sum distribution, they are subject to a mandatory 20% tax withholding and a 10% penalty if under age 59 ½.
  3. Third, if they do an indirect rollover, they must add additional funds to make up for withheld taxes and deposit the savings into a new account plan within 60 days to avoid taxes and possible penalties.

Particularly troubling is that only about 35% of participants received a notice before they made a 401(k) funds decision.

The bottom line is that the retirement plan distribution rules are extremely challenging. If you are leaving your employer and have 401(k) savings, by all means, seek help from an experienced financial advisor.

 

 

By Ian Berger, JD
IRA Analyst

Copyright © 2024, Ed Slott and Company, LLC Reprinted from The Slott Report, 2024, with permission. Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article. Content posted in Ed Slott’s IRA Corner was developed and produced by Ed Slott & Co. to provide information on a topic that may be of interest. Ed Slott and Ed Slott & Co. are not affiliated with Ethos Capital Management, Inc. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.  The tax information provided is general in nature and should not be construed as legal or tax advice. Information is derived from sources deemed to be reliable. Always consult an attorney or tax professional regarding your specific legal, or tax situation. Tax rules and regulations are subject to change at any time. Ethos Capital Management, Inc. is a registered investment adviser. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.