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.
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.
When leaving a job behind, the employee typically has four options:
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:
Regardless of the reason, it's important to understand how expensive it can be to 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.
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.
About the Author - Cashing Out a 401(k) (Last Reviewed on October 19, 2016)