How the DOL’s Fiduciary Rule Affects Your Old 401(k)

Key Takeaways

• A new Department of Labor fiduciary rule is set to go into effect this September. The DOL is worried that financial advisors will put their own interests in front of their clients’ interests when it comes time to make a choice for how you want this money from the 401(k) distributed. There are basically three choices: Roll it over to an IRA, leave it in the company plan, or if you get a new job, roll it to a new company’s plan—but it’s essentially the same thing because it stays within a 401(k)—or take a lump-sum distribution and pay the tax. They want to make sure advisors don’t just knee-jerk default to the IRA rollover.
• The DOL wants advisors to get educated on each option for an old 401(k) and to have a process.
• Despite the potential downsides to taking a lump-sum distribution, there may a reason to do it. The lump-sum distribution is where advisors tend to not know enough. With a tax break in employer securities called net unrealized appreciation, you can turn what otherwise would be ordinary income rates—because if you take money out of an IRA, it’s regular job income, ordinary income. This turns that same income, if you qualify, to long-term capital gain rates, which can be half, if you know about it.

Christine Benz: Hi, I’m Christine Benz from Morningstar. A new Department of Labor fiduciary rule is set to go into effect this September. Joining me to discuss what retirement savers and their advisors need to know about it is tax and IRA expert, Ed Slott. He is author of a new book called The Retirement Savings Time Bomb Ticks Louder.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

DOL Fiduciary Rule 2024 and Retirement Rules

Benz: Let’s talk about this rule. Maybe you can start by talking about kind of the general contours of it. What is it meant to do?

Slott: There’s a lot of money in plans and IRAs, a lot in plans, trillions of dollars.

Benz: Retirement plans.

Slott: Yeah. And when they’re in plans, they’re held generally by workers. The Department of Labor is supposed to protect workers. So, they’re worried—and this has been going on—this is just the latest iteration of it. There was a best interest contract exemption, the SEC rules. They keep having rules to do the same thing, which I’ll tell you in a minute. So, the latest one is the Department of Labor is worried that financial advisors will put their own interests in front of their clients’ interests when it comes time to make a choice for how do you want this money you’ve had in the 401(k) distributed, because there are basically three choices. Roll it over to an IRA, leave it in the company plan, or if you get a new job, roll it to a new company’s plan—but it’s essentially the same thing because it stays within a 401(k)—or take a lump-sum distribution and pay the tax. Who would ever do that? There are big benefits for that most people miss. So, they want to make sure advisors don’t just knee-jerk default to the IRA rollover because they will do better with that because they have assets under management they get paid on, and they want advisors to do what’s in the best interest of their clients, which makes sense.

But I think it was overkill, in my opinion. This latest fiduciary, DOL fiduciary rule, 476 pages. I could have written that in about a sentence. Do the right thing for your clients. Do what’s in their best interest. I say that to advisors. We train them all the time. In every program, I said, “What’s in your clients’ best interest is always in your best interest. That’s the way it should be.” There, I could have done that in a sentence or two. But in that 476 pages, they referenced IRA rollovers 300 times. They’re serious about this big money just going to IRAs without some analysis. And the truth is the IRA rollover for most people is probably the best option. But you should look at the other options.

So, what the Department of Labor wants advisors to do: Number one, they want them to get educated on each option. You just can’t say “I didn’t know anything.” In fact, an earlier iteration of this, the best interest contract exemption, that came out a few years ago, that was a thousand pages, I think. It had this one line that always stuck out at me. It said, “a pure heart and an empty head is not enough.” They said, “You can’t want to do the right thing. You have to know what you’re doing. You need to be educated. You can’t just say, ‘Roll it over to an IRA and we’ll take it from there.’ " There are a lot of reasons to do that. But what they want you to do, and what we teach in all our advisor training programs, they want you to have a process. They want you to sit in front of or talk or communicate with the employee that has a 401(k), your client, let’s say, and if you’re a consumer watching it, that’s you, and say, “Here are your three options. Let me give you the pros and cons of each option. You have the IRA roll over. That’s generally the best.” The way I tell people to go through it, put that on the side for a minute, because that’s generally the best. If you don’t see advantages in the other two, by default, that’s probably the best option.

What are the reasons, the pros and cons, to leave it in a company plan? What are the reasons to take a lump-sum distribution? They want the advisor to have a process to go through that, but they can’t do it if they’re not educated on what the pros and cons, benefits, drawbacks, whatever you want to call it, advantages or disadvantages for each option. They not only have to have a process to do that, but they have to document it when they’re making their recommendation in terms that they believe that it’s in the clients’ best interest.

So, for example, why would you leave money in a company plan? Generally, that’s not the best move; the IRA rollover is the best move for most people. Well, federal creditor protection. It’s ironclad under Erisa. IRAs have some creditor protection on the federal level, but only in bankruptcy, not other judgments. That may not apply to people, but you may have medical people, executives worried. You know what? Let me keep it in the plan. I have Erisa protection. There are other things you can do in a plan. You can have plan loans. I’m not a big fan of those, but you can’t borrow from an IRA. It’s prohibited. You can have life insurance in a plan. It’s a prohibited investment in your IRA. So, there are some reasons. You can get money out earlier if you’re in a plan, at age 55 or even age 50. You don’t have to wait till 59.5 to get it out penalty-free. So, there are some reasons. Another reason is to delay RMDs. If you have a 401(k) balance and you rolled it over to an IRA at 73, you have to start taking RMDs, even if you’re still working. If you leave it in the plan and your plan has this still-working exception, which most do, you can delay RMDs until you retire. So, those are some of the broad advantages of leaving it in the plan or rolling it to a new company’s plan.

What Are Reasons a Client May Want to Take a Lump-Sum Distribution?

Benz: So, you mentioned, Ed, kind of take the money and run option, which I always thought should be marked with a skull and crossbones, like don’t ever do it. But you mentioned that there might be reasons for it.

Slott: No, there is a reason, and it’s bigger than ever.

Benz: What’s that?

Slott: The lump-sum distribution—and this is where advisors tend to not know enough. We teach more advisors in our programs than anybody in the country. And when we talk about a tax break called net unrealized appreciation in employer securities, they start writing, “Oh, that’s a good one.” But if you—and a lot of these decisions, remember, are irrevocable. I’ll explain that in a minute. But let’s say, the advisor just moved a million dollars of 401(k) money over to an IRA. That deal is off the table.

With NUA, you can turn what otherwise would be ordinary income rates—because if you take money out of an IRA, it’s regular job income, ordinary income—this turns that same income, if you qualify, to long-term capital gain rates, which can be half if you know about it. So, who qualifies for this? I always tell advisors to ask the clients two questions. Do you have company stock in your plan? And most people do. You work for IBM, they probably have been piling on IBM stock or whatever company you’re working for. It’s a common thing, a common thing that people do, they invest where they work. That’s the first question. Do you have company stock in your plan? Is it highly appreciated? And now, this is where it’s a big thing again now because the market has run up like crazy. Longevity on the job. You’ve been at a job in some of these big tech companies, for example, for 20 or 30 years, you could have a situation.

I’ll give you an example. You could have a million dollars, say, of Apple stock or whatever in your Apple plan. Only applies to the stock of the company you’re working for.

Benz: And it’s in the plan. It’s not stock I have …

Slott: It’s in the 401(k). So, let’s say you have Apple stock, a million dollars’ worth, but over the years you only paid $100,000 for it when you put it in the plan. That difference between a million and the $100,000 cost is called net unrealized appreciation, or what we call NUA, in employer securities. If you qualify for a lump-sum distribution—and there are qualifiers—there are four of them. The main one is being 59.5 or separation from service. There is also death and disability. But say, you’re able to qualify under one of those. If you instead of rolling that over—now, you could roll the other noncompany stock assets over to your IRA, and that would leave just the million dollars of this Apple stock in our example here. But it has to be a lump-sum distribution. So, the plan has to happen in one calendar year after what we call a triggering or qualifying event, that’s age 59.5 or separation from service. If you take the stock down, that would empty the account because the other funds from the 401(k) were rolled over. You take it. You don’t sell the stock. That’s one of the mistakes—people blow it. You take the stock out in-kind as stock and transfer it to a taxable account, that million dollars, you only pay tax on the cost, $100,000, that original cost. That other $900,000 comes over to your taxable account absolutely tax-free. And whenever you do take that money out, you sell the stock, you automatically get long-term capital gain rates. So, this applies to a lot more people because more people have company stock, longevity at the job, and the market runup. Now any advisor that doesn’t ask that question may have really blown it.

Benz: Well, really good rundown on this fiduciary rule. We’ll have more questions and discussions about this going forward. But thank you so much for being here, Ed.

Slott: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch How to Determine Your Expected Retirement Date for more from Christine Benz.