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Should You Cash Out Your 401(k) When Leaving a Job?


Did you know that 45% of Americans cash out their 401(k) retirement accounts when they leave their employers? Do you know that when you cash out your account before the age of 59 ½ that your withdrawal is not only taxed like regular income but also subject to a 10% early withdrawal penalty?

The decision to cash out your 401(k) when you leave a job should not be made lightly. Are there any times you should cash out you 401(k) early? Perhaps. Here’s when cashing out might be okay, and what to do when you shouldn’t.

What Happens to Your 401(k) When You Leave Your Job

Your 401(k) plan is a retirement account that is sponsored by your employer and can only be funded through regular payroll deductions. So when you leave a job (whether you resign or are let go), you stop contributing to your 401(k), but the balance (less any unvested employer matching contributions) stays in the account until you tell your now ex-employer what to do with it. You can let it sit in your old employer’s account for a long time if you want or, you can choose from three options:

  • Cash out
  • Roll over your old 401(k) balance to a new employer’s plan
  • Roll over your 401(k) to an individual retirement account (IRA) of your choice

Cashing Out Your 401(k)

When presented with these three options, cashing out seems like the easiest option. Whether or not you plan to spend or reinvest your 401(k) money, cashing out seems quick and easy. And it is, but it comes with a big, big cost; not only will you pay the 10% early withdrawal penalty, but you’re risking loosing decades of investment returns if you don’t reinvest the funds.

Now, there are some exceptions to the “don’t cash out your 401(k)” rule. If you are laid off, have no emergency savings, and don’t expect to find new work quickly, you might consider cashing in your 401(k) to stay above water while you look for a new job. In this case, only withdraw as much as you need from your 401(k) each month. That way if you find new work sooner than you expect, you won’t have paid the penalty on withdrawals you won’t need now.

If you have high interest credit card debt and can pay it off with your 401(k) balance (after taxes), whether to keep your 401(k) or pay off debt is a toss up. I hear personal finance gurus advocate both that you should never touch your 401(k) to pay off debt and others that say that when you have debt, eliminating it should be your only priority, so obviously the 401(k) should go towards that.

Mathematically, although the interest rate you’re paying on your debt is higher than what your 401(k) could earn most years, you’re going to leave that money invested for (hopefully) a lot longer than you’ll have your debt. That means the compounding potential of your 401(k) balance is worth more than the interest you’ll pay on debt. Assuming of course, you can get that debt paid off with other sources before you retire!

Rolling Over to Your New Employer’s Plan

When you take a new job and enroll in their 401(k) plan, you’ll have the option of rolling over your old balance to the new plan. Usually your benefits administrator can help you with this. With any qualified rollover you won’t pay taxes or a penalty; your investments just move from one account to another.

If you don’t want to keep track of multiple accounts, this is the way to go. On the flip side, employer-sponsored 401(k) plans often have limited investment options. For most of us that just want to set and forget our investments, that’s not an issue. If you want to be a more hands on investor, read on.

Rolling Over to an IRA

I recommend that when you leave an old job, you do a 401(k) rollover to an IRA. It’s tax free, there’s no penalty, and it gives you the greatest flexibility in managing how you want to invest your retirement savings.

Almost any financial institutions offer IRAs, but not all accounts are created equal. Many banks and credit unions provide CD or Money Market IRAs, but these should only be used by savers nearing retirement who need very low-risk investments. If you’re young, you should be investing your retirement savings in securities. With that in mind, here are a few places to start shopping for a place to roll over your 401(k) into an IRA:

The Bottom Line

Cashing out your 401(k) should only be used as a last resort if you need emergency cash or are willing to trade retirement savings for eliminating some big debts. Rolling over your 401(k) takes a few minutes of paperwork but is generally very easy and will save you from giving 30% of your account balance to the IRS.

If you’re looking for the convenience of one account for all of your retirement savings, roll your 401(k) to your new employer’s plan. If you want more control over your investments and don’t mind having two accounts, roll the 401(k) balance to a traditional IRA.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. yuck, cashing out is a horrible option. However, sometimes it is really pushed. For instance, if you have less than $5,000 in your account you may be forced to cash out.

    I see people cash out their account a lot and I just have to hang my head in disbelief. Individuals who cash their accounts out will not get to experience the true value of compounding interest over many years. For those of us under 30 my advice is roll it into a new plan, roll it over into an IRA, or just let it stay in the old employers plan. DO NOT cash it out unless you are being forced to do so, and even then read between the lines to make sure you absolutely have to. If you do cash it out, do yourself a favor and don’t spend it. Go ahead and put it into an IRA or stocks.

  2. That would really suck if you had less than $5000 and your plan forced you to cash out. That happened to me once at a part time job with a Fidelity plan, but the limit was $1000 and I had like $995 in it. Err.

    Actually I was just rolling over an old 401(k) to an IRA last night and I noticed that the plan (John Hancock) wouldn’t let you roll an account of less than $5,000 into one of their own IRAs. That’s a crappy move, too. What’s even crappier is that the account lost about 40% in value since July, but that’s another story :(

    Finally, I hope that benefits admins and HR folks out there know to counsel people not to cash out. I doubt all do. During exit interviews I’ve had HR people that have simply stated the options–including the penalties–as if one is no worse than the other. That’s one reason that it’s not THAT surprising so many people cash out.

  3. David Nelson says:

    Great basic advice!

  4. I knew all along what I had to do, but this is just reassurance that the smart thing to do is roll over to an IRA. I am in the mist of buying a second home and thinking of getting into my 401k, however putting less of a down payment may be a better option. I am just an average Joe giving heads up to the individuals that are in the same turmoil. Be ready alert and smart about your choices and investments my friends. :)

  5. I only have $1144 in my 401k a previous job, should I cash it out since im short on cash? Please help

  6. I have been reading and researching a lot about 401K and it still seems like we don’t have many choices. We live very frugally already. We don’t buy any of the electronics, tv’s, ‘toys’ that a lot of people buy. We hardley ever go out to eat. We make our meals from scratch, garden, barter, on and on. Every site I go to on how to save money, we are already doing it. We were doing ok and paying all our bills with nothing left over when my husbands job cut everyone’s pay by 10%. It is huge for us. There really is no future there for him. He will never get a promotion and they keep people on forever even though there are alcohol and drug problems and falling asleep at their desk. Anyway, my husbands brother asked him to start working for him in his business where he makes annually about 150,000 or more. It would be a risk for us of course and in the past we have turned him down. But now we are thinking this may be a good time. Our situation is this though, we have about 13,000 in credit card bills. (car repairs, kids in college….really no frivolous spending) and we have a mortgage that we have never been late on. We have not been contributing to my husbands 401K for 4 years now. It also keeps loosing money. We have a couple of options as I see it. We can file bankruptcy and start anew, and ruin our credit. He could quit his job and work for his brother and try and build up a better income. He makes about 40,000 now, I make about 600 a month. (We have 3 kids at home and two in college, working full time is not an option.) If he quit his job, there would be less income at first. We were thinking if we took this option we could cash out the 401K which is about 42,000 right now. Pay off the credit cards, put a down payment on the mortgage for a refinance to get the monthly down (right now 850 per month) and pay off the car which only has 3000 left on it. That way we could live on even less, while he is getting the business started. We know it is risky with the retirement. We are 48 and 44 right now. But if he can go from 40,000 to at least 80,000 in a few years is that a good idea? In his current job there would be no increase in pay and our bills would only get higher. We really feel trapped right now to have about 350.00 taking off his paycheck starting at the end of Nov. Could you give some advice?