Think Twice Before Cashing Out Your 401(k)

If you are thinking about cashing out your 401(k) when you change jobs, think twice. Or maybe three times. You might be about to forsake a financially secure retirement. We are using this Alert to educate investors to the potentially devastating impact cashing even a modest amount of 401(k) assets can have on retirement savings.

 

When you switch jobs before retirement, you usually can choose among several things to do with your 401(k):

  • Leave the money in your former employer's plan 
  • Roll over the money to your new employer's plan, if the plan accepts transfers 
  • Roll over the money into an Individual Retirement Account (IRA) or
  • Take the cash value of your account

It may be tempting to choose the last option and use the money to buy a new television, take a cruise or even to pay off a debt. And you would not be alone in thinking that way: A recent study indicates that 45% of employees cash out their 401(k) plans when they change jobs.*

 

But cashing out of a 401(k) before you are 59 ½ can cost you dearly, both immediately and in the long run:

  • If you do not transfer your money to an IRA or your new employer's plan within 60 days of receiving it, your current employer is required to withhold 20% of your account balance to prepay federal taxes. 
  • If you keep the money, you must pay federal income tax on your entire withdrawal. In addition, you may also owe state tax on your distribution.  
  • Plus, the IRS will consider your payout an early distribution, meaning you could owe a 10% early withdrawal penalty on top of combined federal, state, and local taxes.

When all is said and done, you could end up with a little more than half of your original 401(k) savings!  In addition, you will owe tax annually on any future earnings your lump sum generates. 


 

The High Cost of Cashing Out

The repercussions of cashing out of your 401(k) could be enormous. For example, let's assume you are 30 years old, and have a 401(k) balance of $20,000. If you leave that money in a 401(k) or put it in an IRA, and your account averages a 6% rate of return over the next 32 years, your balance at retirement will be $129,068, even if you do not make any additional contributions during that time. Even if you have a shorter time horizon, you will forgo significant savings opportunities by cashing out your 401(k). For example, if you are 45, your $20,000 will grow to $53,855 in 17 years.

Keep in mind that even if you really need the money, you may be better off borrowing from your 401(k) than cashing it out.  Depending on your plan's terms, you may be able to borrow at a lower rate from your account than you could from a bank or other lender, especially if you have a low credit score. At the very least, you should check with your plan administrator to learn whether this option makes sense for you before you cash out. To learn more about 401(k) loans, read Smart 401(k) Investing.

When you change employers, carefully examine the short and long-term consequences before cashing out of your 401(k) account. After all, when talking about tax-deferred savings plans, time is money.


Resources
 

For additional information on saving for retirement, read Smart 401(k) Investing.

 

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*Hewitt Associates study of large-company 401(k) plans
 

Last Updated: 4/26/2006