All too often, people make a critical mistake when it comes to managing their 401(k) savings: They cash out prematurely. Recent data compiled by Fidelity notes that one in three 401(k) participants has cashed out of his or her plan, often when changing jobs.
For many, cashing out a 401(k) is a relatively easy way to solve a short-term cash crunch, whether it’s due to temporary cash-flow problems created by the loss of a job, or simply paying down a credit card or covering an emergency home repair. But while liquidating your 401(k) may not seem like a big deal, especially if you have a small balance over a long period of time, the consequences of cashing out can be devastating to the average investor.
“Once you withdraw those savings, they’re gone—and they can’t be replaced,” says John Boroff, Fidelity’s director of retirement product management. “While it can be pretty tempting to cash out your 401(k) and use the money to pay off a car or your credit card bill, you may want to think twice before doing so, and weigh the impact of that decision.” The power of tax-advantaged accounts such as a 401(k) is that they allow for pre-tax contributions to compound without taxes eroding that growth. Over time, earnings can generate earnings of their own, helping you accumulate more money than you would in an ordinary taxable account.
Younger investors who cash out miss out on that opportunity, setting their retirement savings back considerably. The average balance that people in their 20s, 30s, and 40s are cashing out is $14,300, according to a recent Fidelity study on 401(k) participants.
Older investors who choose to cash out may be taking away a key part of their retirement income picture. The older a participant is when withdrawing assets, the less likely it may be to generate a sustainable income in a retirement that could last 25 years or more.
The consequences of cashing out are the same whether you do it because you’re switching jobs or because you’ve run into temporary financial trouble and need cash immediately. If you run into financial trouble, you can apply for a hardship withdrawal from your 401(k), but the rules on qualifying can be tricky. If your sponsor offers a hardship withdrawal feature and you are granted one, you will owe ordinary income taxes and unless you qualify for an exception an additional 10% penalty. Taking out a 401(k) loan avoids the taxes and penalties. But you'll have to pay yourself back, with interest. And since your investments will be liquidated to make the loan, if the market shoots up you'll miss those gains. Plus, if you lose your job some employers may require that you pay back the loan(s), especially if you are closing the 401(k) account.
There also is an immediate cost to cashing out. For one, it can generate a large tax bill. Your plan administrator typically automatically withholds 20% of your balance and sends it directly to the IRS to cover the taxes you may need to pay on that withdrawal. “That means you just gave the IRS a huge chunk of the money you’ve been saving for years,” says Elizabeth Titmas, Fidelity’s rollover product director. “That’s money you’re no longer saving for retirement.”
In addition to federal and state income tax, investors younger than 59½ who cash out may have to pay a 10% early withdrawal penalty. The potential result: Cashing out $50,000 in 401(k) savings may leave just $35,000 in cash after 20% withholding and a 10% early withdrawal penalty.
Alternatives to cashing out
Fortunately, there are easy alternatives to liquidating your 401(k) that keep your savings intact— and, potentially, growing. If you’ve left a job and are considering what to do with your 401(k), here are the options:
A traditional IRA rollover. In both 401(k) accounts and traditional IRAs, contributions and earnings can grow tax free until you begin making withdrawals, when you’ll pay income tax on those distributions.
The rollover process is relatively easy—but every plan has different rules and the process can vary. Be sure to sure to request a direct rollover, whereby a check is made payable directly to your IRA provider. “The benefit of a direct rollover is that you won’t face taxes or penalties,” says Titmas.
You also can choose to do an indirect rollover, in which a check is made payable to you. However, in this case it’s up to you to make sure the money finds its way to a tax-advantaged account such as a traditional or Roth IRA. When you cash out your plan in an indirect rollover, your 401(k) administrator may withhold 20% of your account balance. You may need to come up with that 20% out of your own pocket to put the full amount of your 401(k) balance into your IRA. Otherwise, the IRS may categorize the difference between your plan balance and your rollover contribution as a withdrawal—even though they actually have possession of that money in the form of withholding.
This process can be complicated, and any missteps may trigger penalties and taxes. For example, if you don’t deposit the money into a tax-advantaged account within 60 days, it may be taxed as a withdrawal. “With an indirect rollover, it’s up to you to prove at tax time that you did everything right,” says Titmas. “With a direct rollover, you don’t have to deal with that.”
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The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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