Here's why employers can force out small 401(k) accounts once a worker leaves a job

Published Fri, Dec 29 2023 10:30 AM ESTUpdated Fri, Dec 29 2023 11:25 AM EST

Greg Iacurci

Employers can force out small 401(k) accounts once workers leave a job.
Most often, companies cash out balances less than $1,000, and roll those between $1,000 and $5,000 into an individual retirement account in the account holder's name.
A recent law, Secure 2.0, raised that threshold to $7,000.

Tom Werner | Digitalvision | Getty Images

If you left behind a small 401(k) plan account at a former job, odds are your former employer has moved those funds out of the plan. That move may hurt your retirement savings over the long term, experts say.

Current law allows employers to "force out" 401(k) accounts of $5,000 or less if their owners leave the company, perhaps for another job or due to a layoff. The smallest balances, less than $1,000, can be cashed out while the rest can be rolled to an individual retirement account.

Employers don't have to do this, experts say.

They can choose to keep small balances in the plan; however, most do not. To that point, 72% of 401(k) plans don't keep balances of $5,000 or less once a worker leaves, according to a survey by the Plan Sponsor Council of America.

Just 7.5% of plans keep old accounts regardless of size, according to PSCA data.

As more companies have chosen to automatically enroll new hires into their workplace 401(k), such plans have generally amassed more small accounts. Additionally, thousands of workers may have left behind small balances in the Covid-19 pandemic era. In 2022, a record number of workers quit their jobs during the "great resignation."

Companies typically cash out balances smaller than $1,000, meaning account holders get a check, less any income tax and tax penalties owed. Accounts between $1,000 and $5,000 are generally rolled over to an IRA.

Why companies often roll out small balances

A recent law, Secure 2.0, raised that upper limit from $5,000 to $7,000 in 2024. That means more small balances can be rolled out starting next year. However, that's not automatic, as employers must update their plan rules accordingly.

Companies have an incentive to do so. For one, having many small balances can make plan administration more difficult, since companies must issue notices to a larger number of people.

Small balances can also lead to higher fees, said Ellen Lander, founder of Renaissance Benefit Advisors Group. Record keepers — the firms that track account holders' savings, investments and other metrics — often charge based partly on a 401(k) plan's average balance. A smaller average balance generally leads to higher fees, Lander said.

Investors should take action

However, there's tension here. Investors may be better served keeping their money in the 401(k) plan.

If rolled over, 401(k) assets are often initially held in cash-like investments such as money market funds or certificates of deposit, until investors decide to invest those assets differently. There, they earn relatively little interest while also whittling away fees.

Additionally, those who get cashed out generally owe tax penalties if they are under age 59½. Their money is taken out of the tax-advantaged retirement system, denting their future retirement savings.

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But there's good news: Companies must issue notices to workers before forcing out a small balance. That means workers can take action before that happens.

Account holders "should do something" with those funds, Lander said.

"If a participant already has an IRA, the smartest thing would be to take that balance and roll it into an existing IRA or roll it into a new employer's 401(k)," Lander added.

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