80% of workers make this 401(k) mistake when they retire

By Beth Pinsker

Tax repercussions crop up down the road as balances build up, and RMDs get complicated

When faced with too many choices in retirement, many retirees do nothing instead.

What's the first thing most people do with their 401(k) after they retire? Nothing.

That's the finding of a new Vanguard report, "How America Retires 2026," which documents current retiree behavior based on the large population in its orbit of the 401(k) plans the company administers, much like Vanguard's yearly landmark "How America Saves" study.

In particular, researchers dug deep into the accounts of 160,000 former employees in company 401(k) plans administered by Vanguard who were 60 or older and had account balances over $100,000. The balance minimum was selected because these would be people who weren't cashed out automatically for having a low balance, and would be presumed to have some engagement with their accounts. "Retirees at this balance level are more likely to make ongoing decisions about asset allocation, withdrawals, rollovers and retirement income," the report said.

The surprising finding was that 80% of the group that was 60 to 72 - thus before required minimum distributions kicked in - did not touch their accounts in the year after they retired. Some 15% took occasional withdrawals, while 7% took regular installment distributions.

The study was able to look at successive years of behavior, too. The trends continued for about three years, with more retirees rolling over their accounts each year. But still, a significant number of retirees stayed in the plans and left their money alone. For 2021 retirees, for instance, 55% stayed in the plan, while about 9% cashed out in some fashion and 36% rolled over their accounts to an IRA or another 401(k) at a new employer. Two years later, only 34% were still in the plan, 50% had rolled over and 16% had cashed out.

What matters about this is the stagnation. While it might seem like it's good that most retirees are not spending or moving their money around, there are actually financial repercussions to this.

One danger noted in a new study on "retirement drift," by Empower, one of the biggest retirement-plan administrators, found that one in three workers have lost track of old retirement plans. People want to "set it and forget it," but then they actually do forget it. This is another reason why Vanguard focused on accounts with $100,000 or more, reasoning that people would be less likely to forget a high balance.

RMD confusion

Vanguard also found that the lack of interaction between people and their accounts seems to be because of confusion about required minimum distributions (RMDs). Nearly half of retirees misunderstood the rule to mean that they shouldn't take money until RMD age - which for those included in the study was 73, but is 75 for those born 1960 and later. People also think that they are only supposed to take the RMD amount, which is actually a very conservative percentage of the prior year's balance.

If you wait until 73 or 75 to take RMDs and then only take the required amount, you will likely end up with a higher balance at the end of your life than you started with at the beginning of retirement. People who follow this path also likely take Social Security at the earliest point, age 62, permanently lowering their benefit amount. Financial advisers say that most retirees benefit from waiting until full retirement age, which is now 67, or until the maximum benefit age of 70, to start Social Security and should withdraw money from tax-deferred accounts to cover living expenses instead.

For high-balance accounts, steady withdrawals starting early can also mitigate some of the tax impact of large RMDs. If you retire at 65, for instance, and don't start taking RMDs until 75, your account could grow significantly in 10 years, raising that RMD high enough to push you over the limit for Medicare fees known as IRMAA and increasing the taxation of your Social Security income.

Vanguard's answer for this is more education, firmly pressing employers to adopt 401(k) plan designs that are more flexible in retirement and to provide participants with more information.

"The research also shows that plan design matters, with recent retirees more than 40% more likely to remain in their workplace plan when flexible withdrawal options such as partial withdrawals and installment payments are available," said Jeff Clark, Vanguard's head of defined contribution research, in a statement to MarketWatch.

Not a silver bullet

From the data, it might seem like the real problem is people leaving their funds in their 401(k) plans to stagnate, and then potentially forgetting them. But it's not necessarily a magic fix to just get more people to roll over their 401(k)s to IRAs in retirement.

Other Vanguard research finds that many people leave IRA accounts in cash, rather than investing the funds, and that could severely affect account growth. Cash, especially if the money is swept into non-interest or low-interest bearing accounts, is not likely to keep up with inflation. The money would have to be in a government money-market account or other high-yield savings vehicle to even have a chance.

But many people misunderstand the vital difference between a 401(k) and an IRA. In the workplace plan, you can really set it and forget it, because employees are now likely to be auto-enrolled into a target-date fund or other managed portfolio that will adjust for risk as they age. Even if an employee did take an interest and pick their own investments, they'd have only about 15-30 choices of mutual funds, most of which would align to broad-market indexes or sectors.

In an IRA, you have to invest the funds yourself, and there are thousands to choose from. Behavioral finance has long found that people get analysis paralysis after about 30 options.

Vanguard research, as well as that from Fidelity and others, had found that people don't understand that there are multiple steps to the process - roll over the funds, then invest them, then manage them as you go forward. Others get that, but then get overwhelmed by the choices and never come back to select funds once the rollover cash settles.

Education, again, is one solution for this, but there are opportunities for better plan design. IRA custodians can better nudge people to make investing decisions and help them through the process. They can also make "in-kind" transfers more of an option, which means the investments from the 401(k) transfer over exactly the same, rather than being liquidated to cash as the default.

"One of the clearest findings from 'How America Retires' is that there is no single path people follow once they retire," Clark said.

That means there isn't one single solution to make things better, but rather many things to work on for the future.

Got a question about retirement? Fill out our questionnaire or write to me directly at beth.pinsker@marketwatch.com (please put "Fix My Portfolio" in the subject line).

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-Beth Pinsker

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10-31-26 1246ET