New Rules Help Lax Retirement Savers

Young physicians who frequently change jobsoften undermine their own efforts to build asolid retirement nest egg by cashing out theirqualified retirement account every time they switchemployers. New federal regulations may help themresist their own worst instincts.

Studies show that workers with small accounts frequentlytake the cash and spend it on everything fromvacations to cars—but not on their retirement savings.A 2003 study by Hewitt Associates found that 80% ofdeparting workers who had more than $5000 eitherleft the money in their former employer's plan or rolledit into an IRA or a new employer's plan. But 87% ofterminated workers with less than $5000 in theiraccount cashed out their accounts. Small accounts arecommon with workers in low-paying jobs or thosewho change jobs frequently.

Workers who cash out end up with less than the distributedamount. The worker must pay ordinary federaland possibly state income taxes on the amount,and probably an additional 10% early withdrawalpenalty if the worker is younger than 591/2. Someonein the 15% federal and 5% state tax bracket, subjectto the 10% penalty, would end up with only $3500 ona $5000 cash-out. In addition, the worker could losethousands of dollars in future retirement fundsbecause the money will no longer grow tax-deferred.

Automatic Rollover

Under the new federal regulations, which went intoeffect on March 28, 2005, employers whose retirementplan mandates cashing out small accounts whenit doesn't receive instructions from the departingemployee, must automatically roll it into a default IRAon behalf of the employee if the account is worth$1000 to $5000. For accounts valued under $1000,the employer can still cash out the account. Despite thenew rules, workers can still request to cash out theaccount. They can also roll the money directly intotheir own rollover IRA or to a new employer's plan.

The regulations apply to nearly all tax-qualified,defined-contribution plans, including government andchurch plans, and into all workers under age 62 or thenormal retirement age under the plan, which is typically65. The regulations don't apply to surviving spousesor to alternate payees named under a qualified domesticrelations order used in divorce proceedings.

Employers can avoid the automatic rolloverrequirements by amending their retirement plan rulesto eliminate mandatory distributions for smallaccounts or by dropping the mandatory distributionamount below $1000. The money would then be leftin the employer's plan until eventual instructions fromthe former employee are given. A few observers believesome plans will take this approach in order to avoidthe cost of setting up default IRAs.

For workers who were tempted in the past to spendthe mandatory distributions because it was money inhand, the new regulations may encourage them tokeep the money growing tax-deferred toward retirement.But workers still need to take some actions tohelp that money grow.

Keeping a Tab

First, if the employer rolls the money into a defaultIRA, pay attention to how the money is invested. Theemployer is required to put the money into an investmentthat conserves principal, such as a low-earningmoney market that's not going to grow very fast overtime. Consequently, the worker may want to move themoney into investments within the IRA that will likelyprovide a better long-term return.

Second, if the employer's plan drops its mandatorydistributions for small accounts and retains the moneyin the existing plan, the terminated worker may stillwant to move the money into an IRA or anotheremployer plan. That way, workers won't lose track ofsmall retirement accounts left with old employer plans,which is easy to do if they switch jobs often.

Reprinted with permission from the Financial Planning Association (www.fpa net.org),the membership organization for the financial planning community.