The price of cashing out your 401(k)
The stats are not good. More than 40% of the nearly 15 million 401(k) participants changing jobs each year decide to simply cash out their 401(k) instead of rolling it over to a new employer’s plan or to an IRA. Because we are now a mobile workforce – changing jobs an average of five to twelve times over our working years – that could be a lot of retirement dollars lost in transition.
While the 401(k) is supposed to be portable as we change jobs, a main reason for the cash-out seems to be the paperwork hassle -- instead of some kind of financial emergency or necessity. But since every dollar we earn has to really pay two people – our current self and our future self – that cash-out costs us much more than just a paperwork irritation.
Besides the 20% required employer withholding for the federal tax bill upon cash-out, there is also a 10% tax penalty applied to the proceeds if the worker is under 59½ years old. Say that the employee is 35 years old and has $40,000 in their plan – the federal tax withholding is $8,000 and the 10% penalty is approximately $3,200 – leaving the lump sum at $28,800.
Since every dollar we earn has to really pay two people – our current self and our future self – that cash-out costs us much more than just a paperwork irritation.
If that $28,800 was not spent but invested at an average of just 5% through age 65, it would be worth over $124,000 at retirement. If it had been left pre-tax in the 401(k) at that same 5% return, it would be worth over $172,000, before taxes, at retirement.
Even better, if we rolled the 401(k) to an IRA and then converted the IRA to a Roth IRA, it would grow to nearly $140,000 all tax free. (Paying the tax due outside of the IRA account.)
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According to the World Economic Forum, America’s retirement savings gap – what we should have versus what we do have in retirement savings – was $28 trillion in 2015 (which is worse than that of China, the United Kingdom, Canada and Japan).
Of course, there can at times be valid reasons for cashing out, like unavoidable family and medical necessities, living expenses between jobs once savings have been exhausted, life transitions like divorce and other emergencies.
But we would serve our future self best by reserving these cash-outs for just that – rare emergencies.
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Rebecca Walser is a licensed tax attorney and certified financial planner and author of the book Wealth Unbroken, who specializes in the strategic planning of maximizing lifetime wealth while minimizing tax through her practice, Walser Wealth Management . She earned her juris doctor degree from the University of Florida and her Master of Law degree in taxation from New York University. She is a frequent national media contributor.