Helping Clients Prepare for a Great Retirement During the Great Resignation

Key Takeaways:

• The U.S. workforce averaged almost four million resignations a month in 2021 (just over 3.95 million, to be exact), a new annual record. Experts expect that trend to continue into 2022 and have already dubbed this current phenomenon as the Great Resignation.
• Leaving a retirement plan account in a former employer’s plan is the easiest course of action and may make sense if clients are happy with their current investments and plan service-provider.
• Rolling over a retirement plan account after changing jobs is common. Choosing between rolling over the account to an IRA or to a new employer plan depends on a number of factors.
• Cashing out a retirement plan account when leaving employment should be avoided, if at all possible.

We are in the midst of a monumental change in the US labor force. The COVID-19 pandemic has caused employees across the country to re-evaluate their pay and their priorities. In doing so, millions of Americans have decided to make a change. In fact, the U.S. workforce averaged almost four million resignations a month in 2021 (just over 3.95 million, to be exact), a new annual record¹. This record broke the previous record of 3.5 million that was also set very recently, in 2019². Experts expect that trend to continue into 2022, and have already dubbed this current phenomenon as the Great Resignation.

When employees change jobs, those who participate in a defined contribution (DC) retirement plan have a decision to make. What should they do with their existing retirement plan account? Those transitioning employees have four options:

1. Leave the account with their former employer’s plan;
2. Rollover the account into an individual retirement account (IRA);
3. Rollover the account into their new employer’s plan, if one exists; or
4. Cash-out the account.

As financial professionals, we must be ready to guide our clients through this very important financial decision. In doing so, it will be important to help clients think through their current investments and strategy, as well as their unique life circumstances, in order to guide them towards the option that is best for them.

Leave the current plan account in place

So long as an employee’s plan account is at least $5,000, no decision will “have” to be made. By choosing to do nothing, the plan account will remain within the former employer’s plan. For some, this may initially be the easiest course of action, because the choice of what to do with the plan account and in what to invest in outside of the limited choices in the existing plan can be overwhelming. In certain circumstances, remaining in this static position in the former employer’s plan and staying the course may be a perfectly reasonable choice.

For instance, if a client is leaving a large employer who sponsors a large 401(k) plan with millions of employee money to invest, that plan will have access to certain types of low-cost investments (e.g., stable value funds and other institutional-class funds) that are not always available elsewhere. In addition, these low-cost investment options should have been regularly vetted by the plan’s fiduciaries, which may give clients additional confidence that their investments are relatively safe. Some large employer plans may even provide advice and cover advisory fees; an added bonus! In this instance, the client may be quite satisfied with the current investments and service provider. But if circumstances change down the road, these clients are always free to choose to rollover their plan account to an IRA or future employer’s plan at a later time, even years after they leave their current employment.

However, be aware that sometimes these large employers may charge former employees higher administrative and maintenance fees than what they charge their current employees. That is something to point out to clients and encourage them to check on when deciding whether to leave an existing plan account with a former employer’s plan. In addition, be warned that the converse situation to that described in the previous paragraph is also common. For a client who leaves a smaller employer who sponsors a smaller retirement plan, that small plans’ fees may be relatively higher because smaller plans have a harder time achieving economies of scale. In that instance, a client may find lower fees by rolling their retirement plan account over into either an IRA or their new employer’s retirement plan, if a plan is offered.

Rollover the plan account into an IRA

Aside from the potentially lower management and administrative costs in comparison to many defined contribution retirement plans, one other significant factor that may lead clients to rollover their retirement plan account into an IRA is choice! Investment options in an IRA are essentially limitless. Clients can invest in any mutual fund, individual stock, and other investment opportunity. For example, although most defined contribution retirement plans have a solid line-up of stock funds, they may be weaker when it comes to fixed-income options, and older clients may benefit from certain bond funds they cannot find in most DC plans’ fund line-ups. Or perhaps a client wants to hedge against longevity and purchase a guaranteed lifetime income product (i.e., an annuity), which is an investment option that at least for now remains uncommon in most defined contribution retirement plans. For those clients with a bit more investment experience and sophistication, using an IRA to invest in these options, or even real estate, is a possibility. These types of investments are not usually offered through a DC plan.
Another benefit of rolling over an account from a former employer’s retirement plan is the ability to consolidate retirement accounts. Many clients find that combining retirement savings all in one place makes it easier to manage their money and track their progress. This is particularly true for clients who have done a lot of job-hopping, which is increasingly common in today’s workforce. In fact, individuals born in the latter years of the baby boom (1957-1964) held an average of 12.4 jobs from ages 18 to 54!³ If a client has a lot of different defined contribution retirement plan accounts floating around out there with various former employers, the risk is greater that in the aggregate there is a jumble of overlapping funds that may no longer align with their age and risk tolerance.

Once a client consolidates their defined contribution retirement plan accounts into an IRA, they also have better control over partial distributions. This is because whenever a DC plan makes a partial distribution of less than the entire account balance, those partial distributions are almost always going to be pro-rata from both all plan investments and all plan sub-accounts. So if a client wants to take an in-service distribution at age 59½, if they take the distribution from their IRA, it will be easier for them to specify which particular investments to sell, and leave the rest of their money in the fund of their choosing.

Finally, rolling over defined contribution retirement plan accounts into an IRA can offer a number of possible tax-planning strategies:

Roth IRAs

If a client’s defined contribution retirement plan account contains Roth subaccounts, rolling those Roth amounts into a Roth IRA will shield them from required minimum distributions (RMDs). Roth amounts that remain in retirement plans are subject to RMD rules.

Backdoor Roth Conversions

If a client has after-tax amounts in their defined contribution retirement plan account, then they can roll over after-tax amounts into a Roth IRA in what is known as a “backdoor Roth conversion.” This allows those clients to pay tax on the current earnings in the after-tax amount at the time of the conversion, and then to shield all future earnings on that after-tax amount from further taxation after the conversion. This tax-planning technique is important to consider because proposed changes to tax law could take this opportunity away in the near future.

Avoid Automatic Withholding

The IRS requires an automatic 20% withholding on distributions from defined contribution retirement plans. There is no requirement that taxes be withheld from IRA distributions. This allows clients to take out only what they need and allow the rest of their retirement dollars to stay in the IRA and keep compounding.

Income and Estate Tax Planning

Although rules vary from plan to plan, most defined contribution retirement plans try to cash out the account of a deceased participant quickly in a single lump sum paid to the listed beneficiary so that the plan sponsor does not have to maintain control and continue administering an account for a deceased participant. Depending on the income level and net worth of clients, this may cause both income and estate tax headaches. Although inheriting an IRA also has tax implications, IRAs offer more payout options and flexibility, with at least a 10-year period over which to take distributions depending on the beneficiary’s age and relationship to the IRA owner.

Rollover the plan account into their new employer’s plan, if available

Although there are many beneficial reasons to roll over a defined contribution retirement plan account from a former employer into an IRA, there are also a number of factors to consider that may make rolling over an existing retirement plan account into the retirement plan of a client’s new employer a better option. The first factor to think through is the age at which that client plans to retire.

• Late Retirement – If the client wants (or needs) to continue working past age 72, then rolling over defined contribution retirement plan accounts from a former employer’s plan into their current employer’s plan will help them avoid RMDs. RMDs from retirement plans are not required for individuals who continue working past age 72, unless those individuals own 5-percent or more of the business.⁴ If that money from the previous job’s DC plan was rolled over to an IRA, the client would be forced to take RMDs, even if they were still working.

Once such a client older than 72 does eventually stop working, they may then decide to roll over their retirement savings into an IRA based on one or more of the reasons described in the previous section.

• Early Retirement – Conversely, if a client is interested in retiring early, specifically before age 59½⁵, that is another reason to consider rolling over a retirement plan account from a previous employer into a new employer plan. This is because of the Rule of 55.

The Rule of 55 permits those who separate from service with an employer on or after reaching age 55 (age 50 for qualified public safety employees) to receive distributions from their retirement plan without being subject to the 10% early withdrawal excise tax that is generally imposed on individuals who take distributions from their retirement accounts before reaching age 59½. For clients who want to retire in their 50s, having their retirement income in their current employer’s plan when they choose to retire ensures they can take a distribution of their money saved for retirement without having to worry about a 10% tax penalty tacked on to the regular income tax they will also owe on the distribution.

Another important fact distinguishing employer retirement plans from IRAs, particularly for clients who may be worried about protecting their retirement from bankruptcy or other creditor claims (e.g., medical malpractice claims against physicians), is that the Employee Retirement Income Security Act of 1974, as amended (ERISA) shields employer plans from creditors. This means that if someone wins a judgment in court against a client, that creditor is unable to access the client’s assets held in their employer’s retirement plan. IRAs do not offer that same level of protection. Federal law protects up to only $1,362,800 in an IRA, and only in the case of bankruptcy⁶. There are no federal protections from creditors for IRA owners who have not filed for bankruptcy. Some state laws may offer some protection in limited circumstances, but those will vary from state to state.

Finally, a few other things to consider, particularly for younger clients who have recently changed jobs, which may also be reasons to roll over an existing defined contribution retirement plan account into a new employer’s plan:

• Investment Line-up: If the new employer’s plan has low fees and investment options the client likes, rolling over their retirement account into their new employer’s retirement plan may be a smart move. For example, perhaps the new employer’s plan has recently rolled out in-plan guarantees as an investment option, and the client wants to use their rolled-over balance to invest in that opportunity.
• Loans: If a client’s new employer’s plan permits participants to take loans from rolled over amounts, a client who rolls over their retirement account from their previous job may have immediate access to needed cash through a plan loan.

Cash out their plan account

The last option to consider for those clients who are leaving their current employment, is the least likely to be appropriate to recommend to a client. This is because unless your client is at least 55 when they leave their current job (see the explanation of the Rule of 55, above), cashing out their defined contribution retirement plan account will incur a 10% early-withdrawal tax, which will be added to the amount of income tax that will also be due on the amount cashed out of their retirement plan. Unless your client is at least age 55, experiencing a significant financial need, this final option is one to avoid.

Conclusion

Changes in employment are often an exciting time for clients. Yet these job changes also present clients with important financial decisions to make that can also cause them stress and anxiety. Being able to help clients evaluate their financial goals and strategies to help them choose the best of the options described above is critically important to help instill confidence and nurture an ongoing client relationship.