Changing jobs is part of life. After all, baby boomers born between 1957-1964 held an average of 11.7 jobs during their working years. One of the most confusing elements of a job change can be what to do with an old 401(k). Understanding how to best navigate that situation can be critical to keeping you on track to achieve your long-term financial goals.
When you leave your job, you are generally given up to four options for your 401k: 1) cash it out and withdraw the funds; 2) leave your balance in the previous employer’s plan; 3) roll your balance into the new employer’s plan (if eligible); 4) roll assets into a qualified IRA. Cashing out is a popular option, especially among younger employees. Many times, this is the option that is chosen because it’s the easiest and least confusing path to take. However, this is the worst choice to make when trying to position yourself for financial success.
There are several drawbacks to cashing out your 401(k). Below we will outline the main points of concern:
10% Early Distribution Penalty
Cashing out of a 401(k) before age 59.5 subjects the distribution to a 10% early distribution penalty (disregarding the few exceptions). That’s an immediate and significant hit to your retirement savings.
Because a traditional 401(k) is a tax-deferred asset, you’re going to pay taxes on withdrawals from your 401(k) regardless of whether you make that withdrawal now or in retirement. However, there are two primary reasons why it’s beneficial to put those withdrawals off until retirement. First, in the majority of cases, an individual’s income will be higher (and therefore their tax rate is higher) during their working years than when they retire. By making withdrawals during your working years, you lock yourself into paying tax rates that are higher than what you would have paid had you made withdrawals of the same amount during retirement.
The second reason is opportunity cost. Let’s assume you’re 45 years old and you have $300,000 in your 401(k) when you decide to leave your employer. If you leave that $300,000 invested, whether by leaving it at the previous employer, rolling it into the new employer’s plan, or rolling it into an IRA, that money will continue to grow tax-deferred until retirement. In 20 years, that $300,000 would grow to $962,140, assuming a 6% annual rate of return and no additional contributions. However, if you withdraw that $300,000 when leaving your employer, you’re immediately taxed and penalized. Assuming a 25% federal tax rate and the standard 10% penalty, your balance is now $195,000. If you invest that $195,000 in a taxable account for the next 20 years and achieve the same 6% annual rate of return, your account would grow to $625,391, not including yearly income taxes. Leaving the account invested and allowing the account to grow tax-deferred resulted in roughly $337,000 and 54% more.
Arguably the biggest mistake you can make when leaving a company is cashing out your 401(k). Not only does it create taxable income and a 10% penalty, but it also puts you behind on your long-term financial goals. There are other options available for your 401(k) when you leave a company. In the next article, we will discuss the pros and cons of the alternatives and how each may impact your financial plan.