Downside to a Strong Job Market: Cashing Out 401(k)s Early

Thanks to a strong economy and a 17-year high in the employee quit rate, record numbers of U.S. workers are leaving their jobs voluntarily to seek greener pastures with new employers. While most will exit amicably, many are burning their bridges in a potentially more dangerous way—they’re cashing out their 401(k)s when they leave.

About 50 percent of workers ages 20 to 29 who left a job cashed out their defined contribution plans on the way out, according to the upcoming Alight Solutions' 2017 Universe Benchmark report.

But it's not just the millennials: More than four in 10 employees in their 30s and 40s who were laid off, quit or found new work took the cash instead of keeping the money where it was, or rolling it over into their new employer's retirement plan or an IRA.

HB clients, Blake Christian, CPA and James Nevers, CFP® were interviewed in the national media this week about the dangers of cashing out retirement accounts early and offered smarter alternatives.

According to Christian, a partner at Long Beach, CA-based HCVT: It is fairly common for employees to cash-out smaller 401(k) accounts when they switch jobs--a mistake they’ll regret at tax time the following April. “That’s when they realize they are not only paying federal and state tax on the 401(k) funds they cashed out, but they’re are also subject to a 10-percent federal ‘early withdrawal penalty’ plus a state penalty if they are under age 59-1/2 at the time of withdrawal.“

It’s not uncommon for 50 percent of the funds (or more) to get “vaporized by taxes and penalties” said Christian, adding that by that time, “the employee has likely blown the money on a new jet ski or other toy.”

Nevers, an advisor at Soundmark Wealth Management in Kirkland, WA agreed: “When you are between jobs, especially early in your career, that old 401(k) starts to look like a tempting pile of cash you can use for a vacation or to relax for an extra month or two between jobs. The problem is that the $10,000 in your old 401(k) isn’t really the same as $10,000 in your pocket (after taxes).”

Let’s say you are 40 years old and in a 25 percent tax bracket. Since you’re under age 59 ½, withdrawing that $10,000 early will leave you with only $6,500 after taxes. Even worse, explained Nevers, is that you “just hit the re-set button” on your retirement savings. “Remember, retirement savings are for retirement. Only save for retirement after you have set up an emergency fund that can cover your living expenses for three to six months, or for as long as you might expect to be out of work. This will help you keep your retirement funds where they belong, added Nevers.

According to Christian, by leaving the funds with your former employer, the 401(k) fees are generally low and investment choices are often broad.  “You can also roll the 401(k) amounts into an IRA and continue earning tax-deferred retirement savings. If you are expecting to be in a relatively low tax bracket the year you leave your current employer, ask your tax preparer or financial advisor about the possibility of rolling the funds into a Roth IRA. This trigger taxable income (but no penalties), and the Roth IRA can build up TAX FREE after five years and make this pool of money extremely valuable when you retire,” added Christian.

Retirement may seem far away, but time is a powerful factor to have on your side when it comes to retirement savings, said Nevers. “Albert Einstein called compound interest the eighth wonder of the world. It’s even more powerful when it’s inside of your 401(k).”

Conclusion

The key takeaway from our experts is that everyone from young adults to near-retirees can benefit from a little delayed gratification. “Instead of having a little fun today and cashing out your old 401(k), keep it saved,” said Nevers. “You’ll be thanking yourself down the road. Early in your career, you may only have a few thousand dollars saved up in your retirement accounts. It may not seem like much, but thanks to the power of compound interest and the many working years you have until retirement, your accounts have the potential to grow and grow.”

TAGS:  Alight, cashing out 401(k) early, Blake Christian, James Nevers, compound interest, early withdrawal penalty