Low 401(k) account balances: Retain or force out (when employees exit the company)?

Changes to the low-balance distribution limits under SECURE 2.0 will make it easier for plan sponsors to force more participants out of their plan when they leave the company, particularly if they determine small balances are too expensive to maintain.

Under current rules, retirement plans can force participants out if they have a vested account balance of $5,000 or less. The SECURE 2.0 Act increases that limit to $7,000 for distributions starting in 2024.

As of year-end 2021, approximately 36% of accounts have balances of $5,000 or less. The new cap of $7,000 or less increases the account number to 42%, according to an analysis by the Public Retirement Research Lab (PRRL), a collaborative effort of the Employee Benefit Research Institute and the National Association of Government Defined Contribution Administrators (NAGDCA).

Using cross-sectional data from its database, the PRRL examined how the new rules will affect employees at different ages and of different tenures. The analysis found that 28% of accounts with balances of $1,000 or less are associated with participants in their 20s, and older participants typically have higher account balances than younger employees. That means the participant populations most affected by the increased cash-out threshold are employees in their 30s and 40s with balances between $5,000 and $7,000, and 28% of participants in their 30s and 25% of participants in their 40s fall into this category.

Similarly, low-balance accounts are associated with participants who are relatively new to their employer, with nearly three-quarters of accounts with $1,000 or less associated with participants with five or fewer years of tenure. The most accounts newly affected by the threshold increase are held by employees with between two and five years of tenure (38%) and between five and 10 years of tenure (29%), according to PRRL.

However, many plan sponsors may be hesitant to take the opportunity to force participants out of their plans for two reasons, according to Matt Petersen, NAGDCA executive director:

“First, having more assets in the plan helps the plan sponsor negotiate lower fees for all participants, so keeping assets in the plan can be beneficial overall,” said Peterson. “Second, small balances that are forced out are often not rolled into other workplace savings accounts. This could create a tax penalty for the employee if the contributions were in a pre-tax account, and it may reduce overall retirement security, which is the goal of the workplace retirement system in general. Plan sponsors will have to weigh the pros and cons of larger asset pools, and more small accounts to manage.”

Related: Pre-retirement ‘leakage’? Job switchers are cashing out their 401(k)s at alarming rate

Peterson said employers should think about the goals of their plan and whether they want to keep small balance accounts to enlarge their asset pool, or force them out to minimize the number of accounts their service providers need to handle.

“One new option that plan sponsors should carefully consider is auto-portability,” said Peterson. “Many record keepers are working to solve the problem of small balances being lost if they are forced out of a plan. With auto-portability, small balances could be automatically moved to the employee’s next workplace retirement plan, assuming their new employer has one. Auto-portability opportunities vary by recordkeeper and are in their early stages, but it’s worth consideration for plan sponsors who are looking into different options.”