You might be thinking of cashing out 401k when leaving a job. It can be especially tempting to do so in two circumstances: when there’s “only a little bit” in the 401k, and when there’s a whole lot of money in it. If you’re doing a hardship withdrawal as a last resort — such as to stave off foreclosure or feed your family — that can be another matter, but there are still things you should be aware of.
Think twice
Here’s why you should think twice when it comes to cashing out a 401k just because you’re leaving a job. For one thing, according to the IRS, if you take a distribution before age 59 1/2 you’ll generally have to pay an early distribution penalty of 10% additional tax. That’s 10% on top of your normal tax rate — which may be even higher than normal since the distribution itself will count as additional income.
Suppose you normally pay 20% of your income in taxes. Would you like to give up 30% of your money “just because”? You may think “Well, but that still leaves me 70%.” While that’s true, would you feel the same way if a stranger accessed your checking account and withdrew 30% of your money today?
So while it may be tempting to take that cash and pay down bills or bulk up savings, cashing out your 401k is really just a good way to lose money that you could otherwise have kept.
Don’t rob yourself
Believe it or not, cashing out 401k just because you’re leaving a job is even worse than just robbing yourself of your current money. That’s because in addition to the cash you’d be losing up front, you’d also be losing out on the wonders of compound interest — interest that could put a huge amount of money in your pocket over time.
Rolling over your money to an IRA is a much better option than cashing out 401k, and it’s not really much trouble, especially if you do a direct rollover. Doing a direct rollover means that you never have to handle the money yourself. If you have an existing IRA, it’s often just a matter of telling your employer that you want to do a direct rollover to that IRA. If you don’t already have an IRA set up, it doesn’t take much paperwork to get it done. Then you can go ahead with a direct rollover to that.
Take care of future you, too
So while the thought of a little extra cash or a nice windfall may be tempting, remember that your 401k is not “found money”. It’s your future — money you’ll need to live on when you retire. If you’re just wanting a little extra cash right now, hold a garage sale or take on a side job. If you want to buy a house, save up for the down payment.
You’ve done the right thing by setting aside money for retirement so far; now’s the time to keep up the good work.
Posted in Retirement on 06.29.11 with 13 comments.
Great post. I know so many people who end up using their retirement fund to pay off debt that they never seem to get ahead. Plus they tend to use it more than once. Reinvesting is key I would say. it protects you and your money.
Yeah, the only real way to pay off debt is to stop borrowing and then work at it. Plus retirement money is for retirement!
I think whenever you accumulat a chunk of cash, you should not cash it out! Penalties and taxes can eat up a small portion of the savings. This is a waste of money! This is the last possible choice. Do a direct rollover.
Rollover all the way!
Don’t cash out a 401k. There are penalties involved, to be sure, which can be onerous. Just roll it over.
But the big thing is, in my view, retirement money should be viewed as near sacred. Don’t touch it, as you might not have the capacity or marketability to earn enough income when much older.
Yeah, I think too many people view retirement funds as “found money”, when really they shouldn’t be touched until you actually do retire.
Why no discussions regarding issues such as “future taxes may skyrocket, making cashing out at current tax rate + 10% penalty could be a bargain!”, or “what if the gov’t decides to freeze retirment accounts to borrow against them?”. I see no thinking out of the box here, just the same old tired discussions as if nothing has happened to our economy. It’s irresponsible for financial advisors to continue to ignore the $14 trillion in debt, toxic mortgage backed securities, sovereign debt crises all over the world, etc. etc. Financial advisors need to take some responsibility, get into the present and start giving useful advice to those of us who are struggling with retirement decisions.
Well, I think it would be irresponsible to suggest that people go ahead and rob themselves now for certain on the chance that a bunch of random things might happen in the future. Of course something is happening to our economy, which is why it’s a good idea to not blow your retirement money on random crap instead of preserving it for the future. I do think though that if the government decides to start freezing private assets to borrow against them that we’ll have larger problems to worry about. (And btw I’m not a financial advisor.)
Sorry if you took this personally as it wasn’t intended that way. No question people shouldn’t ever blow retirement monies on “random crap”, but they do need to be more aware of current economic issues that may very well significantly impact their decisions.
A few years ago I felt like taking the penalty was a bad idea. Then the market crashed and I lost about 50% of the value.
While what is mentioned here is mostly sound advice, it is based on there being no large corrections (or losses). I wish I had just taken the hit back then rather than letting the market take my money.
Obviously, throwing money away is never good but if you are going to lose it you might just want to pay off all of those credit cards.
One other thing, nobody thinks their 401k is found money. Everyone knows it is money they earned and, in many cases wouldn’t have put in the 401K in the first place if they had other automatic savings options.
Have you earned it back since then though? (Mine recovered.) I don’t know about the found money thing though, I do know people who looked at it that way.
I took a new job with a better future but also took a 20,000 dollar per year paycut. My 401k may ease the loss of pay. I’d like to still have money to travel, etc. too. So many people save and save and die young before ever retiring. There is no U Haul behind the hearse. I say live each day like it’s your last.
I think there’s a happy medium between living each day like it’s your last and putting everything toward the future. I try to do a mix of both.