Recently a friend mentioned he was considering cashing out his 401(k). On the outside I remained calm and quietly listened to his plans for the money, on the inside I was screaming NO! He explained that he was leaving his current job and because he didn’t have a large amount of money in the account, why bother moving it elsewhere?
Sadly, this is how many employees view their 401(k) savings when they change jobs and employers often do a poor job educating employees about their retirement plan options when employment is severed.
Couple this thought with the findings from a recent Careerbuilder* survey which shows 45% of employees plan to stay with their employer for less than two years and you potentially have a situation where the lives of millions of Americans could be impacted negatively.
You may be asking yourself “is it really that big of a deal”? The short answer is, depending on the balance and the age of the individuals involved, yes it can be. Consider this, the government allows you to contribute a certain amount into your company’s 401(k) tax free. That means when you receive your W-2 at the end of the year, funds that you contributed to your 401(k) will not appear as taxable wages. However, if you choose to cash out the 401(k) prior to retirement, the entire balance is now seen as taxable income for that year. As a result, before the funds even hit your bank your employer is required to hold 20% to help pay the income taxes you will owe to the IRS and a 10% penalty will be levied for prematurely liquidating your 401(k).
This means that you lose 30% of the balance, and maybe more depending on your tax bracket, before you see one penny. As much as these short term losses hurt, the long term effects of losing the tax free growth of the account can be even more damaging. Consider this, a $50,000 401(k), if cashed out by a 30 year old, results in a net value of approximately $35,000 to the individual. However, that same $50,000, if kept in a non-taxable account until age 59 ½, would grow to over $500,000 (based on 8% annualized growth). Even more pronounced, if that money was kept in the account until age 70, the end result would be a balance of over a million dollars!
Once you consider all your options, the best one, and often the simplest option is to rollover the 401(k) into an Individual Retirement Account (IRA). By doing so, you simply transfer the money from one non-taxable account to another. Much like you would if you changed banks. Often there’s no cost to processing this transfer. Once the funds have been transferred your investment options actually grow. Rather than being limited by the investment choices provided by your employer’s 401(k) plan, you can choose your own investments from a wide variety of securities including mutual funds, stocks, and bonds among others. With effective investment management, your balance should grow even faster than they would have in the 401(k).
My hope is that you now have a new perspective on how important it is that once you contribute to a retirement account, you exercise fiscal discipline and keep it there. It was certainly eye opening for my friend.
(Past performance is no guarantee of future results. Advice is intended to be general in nature.)