Each month, more than 5 million private-sector employees quit, get laid off or otherwise leave a job, according to federal labor data. Among those with 401(k) plans, a recent study found, about 41 percent drain those retirement accounts upon a job separation.
Workers leaving a job often view the money in their retirement plans as a windfall, says John G. Lynch Jr., a professor at the University of Colorado’s Leeds School of Business and a coauthor of that November 2022 report. And when people perceive a pot of funds as a windfall, he says, they are more likely to cash it in.
“No one is telling you what a terrible idea it is to take money out at this stage,” Lynch says. That includes employers, who he says rarely communicate with departing workers about the importance of preserving the savings they built up while they were there.
Before you make any hasty decisions, remember that withdrawing your hard-earned 401(k) contributions can have both short-term and long-term financial repercussions and hinder your ability to retire comfortably. Here are four reasons not to cash out your retirement plan when you leave a job, and what steps to take instead.
1. You’ll pay up front
Cashing out a retirement plan before you reach age 59½ typically means paying a 10 percent tax penalty for early withdrawal — on top of any regular income taxes you owe on the money.
Another argument for waiting: If you’re like most retirees, your income will be significantly lower than when you were working, potentially dropping you into a lower tax bracket.
“If you believe your effective income tax will be lower in retirement than it is today, an early distribution will come with a higher tax bill,” says Bennett Pardue, a partner and financial adviser with Equitable Advisors’ New Canaan Group in Connecticut.
For instance, say you have $20,000 in a 401(k) when you leave your job, you’re in the 22 percent federal tax bracket, and you live in Illinois, which has a flat state income tax of 4.95 percent. Cashing out will leave you with only $12,610, after coughing up $5,390 in taxes and the $2,000 penalty.
2. You lose growth potential
By contrast, that $20,000 will almost certainly become a whole lot more if you leave it alone until you retire. The money in workplace plans is invested, primarily in securities such as stocks and bonds; if you take it out, it’s no longer earning annual returns that are reinvested, further fueling growth. That can leave a dramatic gap in your financial security in retirement.
Suppose you’re 40 when you switch jobs. The $20,000 in your “old” 401(k), if kept intact, would grow to just over $108,000 by the time you hit 65, assuming an average annual return of around 7 percent. (The S&P 500 has averaged a 7.5 percent return over the past 30 years.)
“No one is telling you the compounded value of those savings by the time you retire,” says Lynch. “Let’s say you’ve been working for someone for six years. When you change jobs and cash out, you’ll have to wait another six years to retire and save much more aggressively than you were before.”
Building your retirement savings is a long game, and cashing out early will disrupt your progress, says Taylor Kovar, founder and CEO of Kovar Wealth Management in Lufkin, Texas.
“Taking an early payout from your retirement plan is a bit like fast-forwarding a movie,” he says. “You might satisfy your curiosity quickly, but you’ll miss the full plot.”
3. You risk running short in retirement
Put another way, that short-term gain could blow a hole in your future nest egg, with potentially serious consequences for your ability to maintain a comfortable standard of living in retirement or keep up with rising health care expenses as you age.
“Cashing out early may have negative implications, the most severe of which could be superannuation or outliving your retirement funds,” says Devin Carroll, owner of Carroll Advisory Group, a retirement planning firm based in Texarkana, Texas. “Even if you don’t get to that point, you may still jeopardize your ability to lead the lifestyle you planned for in retirement.”
The financial strain of losing a job can make it tempting to cash out, but it should be a last resort. If you have other savings, tap those first. Look for ways to cut your spending while you find new work.
“Live within your means so that you are saving and not having to contemplate robbing the future you,” says Christopher Manske, a certified financial planner and president of Manske Wealth Management in Houston. “The best alternative to cashing out your retirement plan is to seriously consider the needs of that future you.”
4. You can easily roll it over
Leaving your job can be stressful, but managing your retirement plan doesn’t have to be. In most instances you have three relatively seamless options for dealing with an old 401(k) or similar account without incurring taxes or early distribution penalties or, in effect, robbing your future self.
Leave it as is. You can keep the retirement plan you had if your previous workplace allows it, which is generally the case if there’s at least $5,000 in it. You might want to do that if the existing account has low fees and investment options you like, but keep in mind that you won’t be able to make contributions or get an employer match.
Under IRS rules, if the account contains less than $1,000 when you leave, your ex-employer can cash it out and send you a check. You’ll have 60 days to deposit the money in another retirement account to avoid taxes and penalties.
If the balance is $1,000 to $5,000, your old workplace is generally required to roll it directly into an IRA, unless you instruct them otherwise. The limit goes up to $7,000 in 2024 under the SECURE 2.0 Act, a package of federal provisions designed to enhance retirement savings.
Roll it into an IRA. If you can’t or don’t want to keep your previous employer’s plan, moving the money into an individual retirement account (IRA) allows you to avoid cash-out costs and maintain tax advantages.
You can open an IRA with a bank, brokerage or financial adviser, which allows more hands-on control of your portfolio, or go with a robo-adviser, which largely automates the process and generally means lower fees. Once you’ve established the new account, contact your former employer’s retirement plan administrator and request a rollover. They’ll provide you with paperwork to execute the transfer.
Roll it into a new 401(k). If you start a new job that offers a retirement plan, you can transfer the balance of your old account into the new one. Contact your previous plan administrator, who can authorize a direct rollover into your new account.
Joining the new plan doesn’t require you to drop your old one, if you like it; other than the rules on small balances, there’s probably nothing stopping you from keeping both. Just don’t forget about the old 401(k) — millions of Americans do, leaving hundreds of billions in savings unclaimed, according to Capitalize, a company that facilitates retirement plan transfers.
