Should Payroll Keep Managing Ex-Employees’ 401(k)s? A Practical Guide for Small Employers

Hook: Why small employers dread the question “Can I leave my 401(k) with my employer?”

For small-business owners and payroll teams, a departing employee’s 401(k) often looks like an unresolved admin ticket: a liability that consumes time, creates questions about tax reporting, and invites fiduciary scrutiny. The wrong choice can trigger penalties, extra tax paperwork, and unhappy former employees. This guide walks operations teams through the practical decisions, payroll responsibilities, and compliance traps of retaining ex-employees’ 401(k) accounts in 2026.

The situation in 2026: why this matters now

Recent years (late 2024 through 2025) brought two converging trends that change how small employers should think about retained 401(k) accounts:

• Recordkeepers and fintech providers accelerated automated rollover and portability services—making rollovers easier for participants while offering employers lower administrative burdens.
• Regulators and enforcement authorities increased scrutiny on plan governance and participant communications, particularly where former employees’ accounts are left in plans and small balances accumulate.

What this means: keeping ex-employees’ 401(k)s on your plan is not just a convenience decision — it’s a fiduciary and payroll operations decision. Small employers must balance participant service with legal exposure and tax-reporting duties.

Quick answers operations teams need

• Can you leave a 401(k) with the employer? Yes—most plans permit former employees to retain accounts if the plan’s terms allow it.
• Is it always the best choice? Not necessarily. Retention can increase administrative burden, fiduciary risk, and costs that fall back on the employer.
• Who issues Form 1099-R? Typically the plan recordkeeper or trustee issues Form 1099-R for distributions. Payroll should coordinate to ensure accurate reporting and withholding where applicable.

Payroll’s core responsibilities when an employee leaves with a 401(k)

Payroll teams do not operate in a vacuum. When an employee departs, payroll must work with HR, the plan fiduciary (often the owner or a committee), and the recordkeeper to manage the retirement account transition. Key responsibilities include:

1. Confirm the plan’s rules and your role. Check the plan document and summary plan description (SPD) for permitted options on post-employment accounts (retention, in-plan rollovers, automatic distributions, cash-outs).
2. Collect and verify contact information. Maintain current addresses and personal emails so the recordkeeper can reach former participants for rollover and distribution paperwork.
3. Initiate required communications. Provide departing employees with required rollover notices and options in a timely manner—document delivery and date sent. Use tested subject lines and proof-of-delivery checks (see communication tests and audits) to reduce dispute risk.
4. Coordinate tax withholding and reporting. Work with the recordkeeper on whether a distribution occurred and who will issue Form 1099-R; if payroll issues a distribution check, ensure proper withholding rules are applied. For complex handoffs consider a compliance review—see resources on compliance-first workflows.
5. Track small-balance and uncashed distributions. Flag accounts below plan-specified thresholds and monitor uncashed checks to avoid stale-dated payments and escheatment surprises.
6. Document decisions and approvals. Keep a compliance file with plan amendments, committee minutes, and communications regarding ex-employee accounts—adopt robust document storage and audit-trail best practices to make audits painless.

Step-by-step offboarding checklist for 401(k) accounts (practical template)

Use this sequence for each departing employee to reduce risk and simplify payroll workflows.

1. Day 0–3: HR notifies payroll and plan admin
   • Confirm termination date, last payroll, and final contribution status.
   • Notify recordkeeper of termination event (name, SSN, address).
2. Day 3–10: Deliver options and secure acknowledgements
   • Send the SPD excerpt and rollover/distribution options via email and mail. Archive proof of delivery.
   • Offer in-plan rollover, direct rollover to IRA, or distribution options per plan rules. For printed templates and low-cost notices consider print/template tips.
3. Day 10–30: Confirm action or default policy
   • If the employee selects a direct rollover, coordinate trustee-to-trustee transfer.
   • If no action and plan permits, apply default policy (e.g., retain account, auto-rollover to IRA, or cash-out per plan document).
4. By January 31 (following tax year): Finalize tax forms
   • Confirm with recordkeeper who will issue Form 1099-R for any distributions performed in the calendar year.
   • Ensure payroll carries documentation of withheld amounts if payroll processed a distribution; maintain an audit trail consistent with audit-trail best practices.
5. Ongoing: Monitor uncashed checks and escheatment
   • States have different unclaimed property rules—document steps taken and consult the CFO or counsel before escheating funds. Follow compliance checklists for implementation and documentation (see compliance resources).

Tax reporting realities: Form 1099-R and withholding basics

Handling post-employment distributions triggers tax reporting duties that intersect with payroll. The key points every small employer should know:

• Who issues Form 1099-R? The plan trustee or recordkeeper normally issues Form 1099-R to the recipient and files with the IRS for any distribution during the year.
• Rollover vs. distribution: Trustee-to-trustee direct rollovers are not taxable events. Indirect rollovers (participant receives funds and redeposits within 60 days) may be subject to mandatory withholding rules and require careful tracking.
• Mandatory withholding: When eligible rollover distributions are paid directly to the participant (not direct rollover), federal mandatory withholding rules generally apply. Payroll must coordinate if it issues a distribution check.
• Timelines: Form 1099-R is typically furnished to participants by January 31 for the prior calendar year; filing deadlines with the IRS depend on whether paper or electronic filing is used—confirm the recordkeeper’s schedule and document delivery.

Practical tip: Don’t assume payroll is free from tax-reporting liability just because the recordkeeper handles investments. If payroll issues or co-issues distributions, payroll must supply accurate withholding and backup documentation.

Fiduciary risk: what payroll and owners must watch

Retaining former employees’ 401(k) accounts implicates the plan’s fiduciaries. Small employers—often plan sponsors and fiduciaries—must ensure they are not creating avoidable risk:

• Fee monitoring: Are former participants paying excessive recordkeeping or investment fees? Fiduciaries must evaluate fees for reasonableness, even for terminated participants.
• Participant communications: Poor or late communication about rollover options can result in plan sponsor liability. Keep records of notices and delivery methods—run communication tests as recommended in communication testing guides.
• Lost or missing participants: Plans must take reasonable steps to locate deferred vested participants; using a locator service or ML-enabled matching and auto-portability solutions reduces risk.
• Plan terms and amendments: Any default distribution or auto-IRA rollover program must be implemented via plan amendment and communicated per ERISA requirements.

“Fiduciary risk is as much about documentation and process as it is about dollars. If you can show consistent, reasonable procedures, you reduce audit and litigation exposure.”

When keeping an ex-employee’s 401(k) makes sense

Retention can be the right choice in certain circumstances:

• The account balance is substantial and the participant prefers to remain in the employer plan’s investment lineup.
• The recordkeeper offers superior investment options and low fees compared to available IRAs or other plans.
• Administrative costs for maintaining deferrals and distributions are manageable, and the plan has clear policies for handling former participants. Store policy documents and meeting minutes in a secure document repository to ease audits.

When to push for a rollover or distribution

Consider facilitating or mandating a rollover when:

• Accounts are small and the recordkeeper charges flat fees that eat into balances.
• Tracking and locating former employees creates persistent administrative overhead.
• State unclaimed property laws create risk of escheatment and tax complications.
• Fiduciary assessments indicate retention increases the risk of fee challenges or legal exposure.

Practical templates: what to say to departing employees

Clear, concise communication reduces confusion and follow-up work. Use short emails with bulleted options and next steps. Example:

Subject: Your 401(k) options after leaving [Company]

Hi [Name],

Following your departure on [date], here are your 401(k) options:

• Keep your account in the [Company] plan. [Explain any fees or limitations].
• Direct rollover to an IRA or to a new employer’s plan. If you choose this, we will coordinate with the recordkeeper.
• Request a distribution (tax and penalties may apply).

Please reply by [deadline] or contact our plan administrator at [contact info]. If we don’t hear from you, the plan’s default option (detailed in the SPD) will apply. For printable notices and low-cost templates try the guidance on notice design and print.

Case study: How a 12-employee bakery reduced risk and cost

Acme Bakery, a 12-employee shop, used to keep all former employees’ 401(k)s on plan. As five employees left over two years, payroll’s admin time doubled and the recordkeeper assessed monthly flat fees that eroded small balances. The owner audited options, amended the plan to use an auto-rollover to an IRA for balances under $2,500, and switched to a recordkeeper with an auto-portability feature. The results:

• Payroll time spent on offboarding decreased by 60%.
• Participant balances improved because IRAs had lower fees for small accounts.
• Fiduciary exposure dropped after documenting the amendment and communications—store the documentation in a secure repo and follow audit-trail practices.

2026 trends and what to watch for next

As of early 2026, three developments are shaping employer decisions:

• Wider availability of automated rollovers and portability platforms. Vendors now offer one-click trustee transfers and “robo-rollover” services. Employers can reduce friction by implementing direct-rollover and auto-portability workflows.
• Increased regulatory focus on participant outcomes. Auditors are looking for documentation showing plans actively minimize cost drag on participant balances and resolve lost-participant issues.
• AI-enabled reconciliation and monitoring. Payroll and recordkeeping tools increasingly use AI to flag lost participants, reconcile contributions, and automate 1099-R coordination—saving time but requiring oversight for accuracy.

Decision framework: retain, roll to plan IRA, or mandate distribution?

Use this quick scoring method to decide for each former participant:

1. Balance size: Large (+2), Medium (+1), Small (0)
2. Recordkeeper fees vs IRA options: Favorable (+2), Neutral (+1), Unfavorable (0)
3. Administrative burden: Low (+2), Moderate (+1), High (0)
4. Fiduciary exposure (documented policies): Low (+2), Moderate (+1), High (0)

Scores 6–8: Consider retention if participant prefers it. Scores 3–5: Encourage direct rollover to IRA or new plan. Scores 0–2: Consider auto-rollover or cash-out according to your plan document and legal counsel.

Final actionable takeaways

• Document everything: Plan amendments, notices, and proof of delivery reduce claims risk. Use robust storage and audit trails (cloud NAS guidance and audit-trail practices).
• Coordinate early: Notify your recordkeeper immediately on termination events and delegate tax-form responsibilities clearly.
• Adopt automation: Implement automated rollover and portability services where feasible—2026 tools reduce friction and auditing risk (automation & AI).
• Limit exposure: Use thoughtfully drafted plan defaults (auto-rollovers or in-plan options) approved by counsel and communicated to participants.
• Train payroll: Ensure payroll understands Form 1099-R workflows, withholding rules, and when to escalate to plan counsel or benefits administrator (consider a compliance playbook from compliance-first practitioners).

Where to get help

If you don’t have a dedicated ERISA counsel or benefits consultant, start with these steps:

• Ask your recordkeeper for their lost-participant and rollover capabilities and request a written process flow.
• Schedule a compliance review with a benefits attorney to align plan documents with operational realities (see compliance resources for small teams).
• Run a pilot on auto-rollovers for small balances before a full plan amendment to measure operational impact.

Closing: make a proactive plan before the next exit

Leaving an ex-employee’s 401(k) on your plan may feel convenient in the short term, but in 2026 it’s a strategic decision that touches payroll accuracy, tax reporting, and fiduciary exposure. The best small-business approach balances participant service with documented policies, automation, and a partnership with a capable recordkeeper. Take these practical steps now—document your process, coordinate tax reporting, and adopt modern rollover tools—to convert a recurring pain point into a predictable operational workflow.

Call to action

Download our free 401(k) offboarding checklist and sample employee notice template, or schedule a 30-minute compliance review with our payroll and benefits team to map the simplest, low-risk workflow for your business.

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• Audit-trail best practices to support regulatory reviews
• Notice and template design tips for low-cost employee communications
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