When you leave a company – whether on your own terms or not – you may panic about the changes happening to your employer-sponsored retirement account. While you have several options for dealing with your old 401(k), some strategies are better than others.
A recent Harvard Business Review study found that 41.4% of the 162,360 employees who left between 2014 and 2016 cashed out their 401(k) savings at the time of separation. Unfortunately, for these employees, cashing out is rarely the right move and may even destroy your retirement security.
That’s why you should never cash out your 401(k) if you can help it, and what you should do about it.
Why you shouldn’t cash in your 401(k)
It’s understandable why your instinct might be to withdraw cash from an employer-sponsored retirement plan. You may be nervous about the market, worried about not having cash reserves from your old job, or confused about the rollover process in general. However, the consequences of withdrawing early may outweigh the benefits. Experts often advise against cashing out for the following reasons
Taxes, taxes, taxes
In addition to the employer match, the main benefit of a 401(k) plan is the tax advantages of your savings. If withdrawals are made early (i.e., before you reach age 59½), the IRS will typically require automatic 20% tax withholding. So, let’s say you withdraw $10,000 from your 401(k) plan before retirement age. Already, you may only get about $8,000 in withdrawals (at least before the tax refund).
Additional Penalty Tax
In addition to the 20% withholding tax on early withdrawals, you will face a 10% tax from the IRS as an early distribution penalty. This means that an additional $1,000 is deducted from the assumed $10,000 withdrawal, reducing your actual income to $7,000.
Lock in losses
When the market is down, you may be tempted to pull your money out, but it’s best to keep the big picture in mind. And that big picture may include a market rebound and many more years of growth. Don’t sabotage yourself by locking in losses during a market downturn.
Roll over your 401(k) instead
Instead, you should merge your old 401(k) into another qualified retirement plan. The obvious advantages are maximizing your savings, gaining a broader range of investments, and the convenience of reduced tracking. This is our guide to help you find old 401(k) savings from previous jobs so you can make the most of your retirement savings.
If you can’t roll over your old 401(k) plan into a new one, your next best option is to let it grow before you choose to cash it out early.
For large retirement savers, the silver lining from record inflation is the record cap increase in your 401(k) in 202 3. For new retirement savers, here’s our beginner’s guide to getting started with a 401(k).
