The Devastating Effect of Cashing Out Your 401(k)

by Ron Haynes

Far too many people, 45 percent in 2008, choose to cash out their 401(k) account when they leave a job. Given the economic conditions, I’d be willing to bet that number has risen. What generally happens next involves shopping sprees, vacations, and drinks on the house … and a huge amount of taxes.

Changing jobs is a fact of life – you will probably change jobs at least a few times over your career. As a matter of fact, the average number of job changes for today’s college graduates is twelve! Almost half of all people who change jobs and have a 401(k) will take their retirement money in the form of a check made out to them personally and will then spend the money earmarked for their retirement on consumable items … after paying 20% to 30% in taxes and another 10% penalty if they’re under 59 1/2. All in all, they lose approximately 40 to 50 percent of their balance.

The numbers

Assume Ashley is a 35 year old in the 28% tax bracket and plans to retire at age 65. Her 401(k) balance is $50,000.

  • If she cashes out, she will net only $31,000.
  • If she rolls her money into a Scottrade IRA, and achieves an 8% return, at retirement she will have $546,786 (compounded monthly).
  • The difference – with no other contributions – is an astounding $515,786.

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That difference is due to the incredible and powerful effect of compounded interest. It may be an urban legend, but when asked to name the greatest invention in human history, Albert Einstein is said to have simply replied “compound interest.”

Better options than cashing out your 401(k)

You don’t have to take the money and run! It’s probably better for you in the long run that you DON’T!

1. You can leave your money in your former employer’s plan.

Some companies will allow you to leave your money in their 401(k) plan despite no longer working there. Usually there are balance minimums ($1,000 to $5,000). If you like your investment options under your former employer’s plan and the fee structure isn’t out of line, this is an okay choice.

2. You can move your money to your new employer’s plan.

The kicker is: do you like the investment options offered under this new plan as opposed to the old plan? If the answer is YES, then your life probably got a whole lot easier from an administrative point of view, plus you’ll be able to continue making contributions to your retirement plan.

3. You can roll your 401(k) into an IRA.

I’m partial to Scottrade because that’s where my personal IRA is located, but you can also roll your money into an E*Trade, optionsXpress, or Zecco IRA as well. If you plan on actively trading stocks, be sure to examine your trading costs. Both Zecco and optionsXpress have very low trading costs at only $4.95. Each of these brokerage houses has rollover experts to help you handle the details and rolling over all your other retirement accounts into one at one of these brokerages will help you maintain your proper asset allocation. Whether a Roth or a Traditional IRA is right will depend on your income level and your personal retirement plans.

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Rolling over your IRA is simple

You have two options for getting the ball rolling:

  1. Sit down with the human resources or plan administrator at each of your former jobs and fill out the appropriate paperwork, then have the company write a check for the amount of your account balance.
  2. Utilize the rollover experts at one of the brokerage houses.

Guess which one is easier?

One 401(k) rollover caveat

DO NOT have the check made out to you personally. If this happens, the money will be treated for tax purposes as income, just as if you cashed out. Instead have the money wired to the brokerage house you’ve chosen. It’s really easy if you choose Scottrade since they have hundreds of local offices all over the country.

If you DO take possession of a check (made out to the brokerage house), you’ll have only 60 days to deposit it into your IRA. Miss that deadline and you’ll incur the 10 percent early withdrawal penalty. Ouch!



About the author

Ron Haynes has written 988 articles on The Wisdom Journal.

The founder and editor of The Wisdom Journal in 2007, Ron has worked in banking, distribution, retail, and upper management for companies ranging in size from small startups to multi-billion dollar corporations. He graduated Suma Cum Laude from a top MBA program and currently is a Human Resources and Management consultant, helping companies know how employees will behave in varying situations and what motivates them to action, assisting firms in identifying top talent, and coaching managers and employees on how to better communicate and make the workplace MUCH more enjoyable. If you'd like help in these areas, contact Ron using the contact form at the top of this page or at 870-761-7881.