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.
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.