Cashing Out a 401(k)
- Last Updated: Thursday, 02 April 2020
When leaving a job, it’s tempting to pull money out of a 401(k) account. In fact, studies conducted by some of the leading benefits administrators indicate that nearly 50% of employees take the money out of their retirement account when they leave their jobs. That statistic is unnerving, because cashing out a 401(k) plan can be expensive in the long run.
In this article, we’re going to start off with a brief discussion of retirement plans. Next, we’ll explain the various options employees have when they leave a company, and why more employees are choosing to cash out their retirement plans. Then we’ll use an example to demonstrate why certain choices can be expensive over the long haul. Finally, we’ll provide the pros and cons of this approach.
Money for Retirement
Whether it’s a traditional pension with a cash value, a 401(k) or a 403(b) account, the purpose of these plans is to provide income when retired. A well-funded plan allows for a high standard of living once retired and / or allows individuals to enjoy retirement; without the worry of looking for a source of supplemental income in their golden years.
When employees leave a job behind, it’s tempting to look at these account balances and think about how the money could be used today. If forced out of a job, the money could ease the financial burden, or could be used to pay down debt.
Studies conducted by Hewitt Associates back in 2004 indicate 45% of workers pulled the money out of their 401(k) accounts when they left their jobs. Even more alarming, that same study found nearly 70% of workers under 30 years of age cashed out. This trend, along with the growing popularity of defined contribution plans, means many of these workers are choosing to ignore the real purpose of these funds.
Cash Out Options
When leaving a job behind, the employee typically has four options:
- If the employer’s plan allows, and most will, the money can be left with the former employer. Unfortunately, the ability to actively manage the account may be restricted.
- Rolling the 401(k) plan into the new employer’s plan is the ideal arrangement from a retirement planning standpoint. If at all possible, this should be an account-to-account transfer, whereby the old plan’s administrator works directly with the new, and the employee never takes possession of the money.
- If a cash distribution is received from a qualified retirement plan, a rollover to a Traditional IRA is possible. That distribution must be rolled into the IRA within 60 days. The transaction is not taxable, but needs to be reported on IRS form 1099-R.
- Finally, if a true cash out occurs, and the accountholder is not age 59 1/2 or older, there is a very good chance that a significant amount of the money received will be needed to pay both the income taxes due as well as a 10% tax penalty.
Why Cash Out?
As mentioned earlier, the purpose of a retirement account is to provide a steady source of income when retired. With that in mind, it’s reasonable to assume that cashing out should be avoided at all costs; that’s simply not true. In fact, there are both good and bad reasons to do so:
Don’t Cash Out
- Pay Down Debt: While it might be tempting to use the money to pay down debt, or even a student loan, starting a retirement plan over, and the tax penalties, are a heavy price to pay. A better alternative is to stop funding the retirement plan, and use that income to pay off these loans.
- Buy a Home: A solid financial plan will provide for both retirement and expenses like a home. Don’t sacrifice a retirement plan to buy a home. Begin a savings plan that allows money to be set aside towards a down payment.
- Medical Emergencies: It’s impossible to place a price on someone’s health. When alternatives are exhausted, and it’s an emergency, then it’s time to cash out. Check the hardship withdrawal rules because this expense may qualify; meaning it’s possible to avoid the 10% federal income tax penalty.
- Go Back to School: One of the best investments ever made is in an education. Not only will an individual qualify for higher paying jobs, but this may also qualify as a hardship withdrawal.
- Avoid Foreclosure: This is yet a third good reason to pull money from a retirement account. If this is a short-term hardship, and not a long-term problem, then save the home from foreclosure.
Regardless of the reason, it’s important to understand how expensive it can be to cash out.
Example: Keep It or Cash Out
We’re going to use a simple example to illustrate the economics at play. Here we have a 40 year old pulling $250,000 out of their retirement account. The Cash Out assumptions include an individual in the 28% federal income tax bracket, and a state income tax bracket of 6%. The Keep It assumptions add inflation at 3% per year and a modest return on investment of 6%.
The Cash Out option loses $110,000 to taxes, netting $140,000 to spend. At age 65, the Keep It option was worth $1,073,000. Adjusting for taxes and inflation, the investment would be worth $370,000 in today’s dollars.
The $130,000 difference in the value of each option illustrates how expensive cashing out is to the account owner. Additional scenarios can be illustrated using our Cash Out Calculator.
Summary: Pros and Cons
We started this article by stating the purpose of a retirement account is to provide income once retired. Adding to the importance of these accounts is the fact employers continue to move away from traditional pensions and towards defined contribution plans. This means the money in these accounts may very well be the only source of retirement income. Not only is cashing out risky, but the example above proves it’s expensive too.
Perhaps the only advantage offered is the flexibility a retirement account may provide in the event of a medical or financial emergency. While the long-term implication may be a delayed retirement, it’s reassuring to know the money can be accessed if a crisis strikes home.
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