The most remarkable development in America’s private sector retirement system is not the shift away from the old defined benefit plans that began around 1980 and are now almost complete.
Rather, it is a shift from 401(k) plans, which replaced defined benefit plans, to individual retirement accounts. Total IRA assets now exceed the amount of 401(k) plans by $7 trillion (see Figure 1).
The transition from a 401(k) to an IRA moves employee funds into a different regulatory environment. The Employee Retirement Income Security Act of 1974, which covers 401(k) plans, requires plan sponsors to operate as fiduciaries and act in the best interests of plan participants at all times.
By contrast, the standards of conduct for broker-dealers selling IRA investments are far less protective than ERISA’s fiduciary duties of loyalty and prudence, which courts have consistently described as “the highest standard known to the law.”
Additionally, in a 401(k) environment, there is greater emphasis on disclosing expenses in an easy-to-understand format than in an IRA. Most importantly, a 401(k) puts more emphasis than an IRA on keeping funds in the plan until retirement.
In fact, all withdrawals from 401(k) plans and traditional IRAs before an employee reaches age 59½ are subject to a 10% penalty (in addition to federal and state income taxes). Exceptions include distribution of large medical expenses, hardship caused by permanent and total disability, and periodic payments over a lifetime.
However, IRAs allow withdrawals for three other reasons: to pay for higher education; up to $10,000 to purchase a new home; and, for those who have been unemployed for 12 weeks or more, to pay for health insurance.
In addition to being exempt from the 10% penalty tax, the barriers to accessing funds for an IRA are much lower than for a 401(k). Importantly, 401(k) withdrawals can only be made when changing jobs or for hardship reasons, whereas IRA withdrawals can be made at any time and without good reason.
Additionally, 401(k) hardship withdrawals involve interactions with plan administrators, filing of paperwork, and, at least in theory, justification for the withdrawal. The emotional and practical burden of this multi-stage process can hinder exit. In contrast, IRA providers generally discourage withdrawals before retirement age.
