When you leave a job, your energy and attention shifts to your next chapter. But there’s one housekeeping task tied to your old job that you’ll want to consider carefully—namely, how to handle an old 401(k).
Making the right move with that money can be worth $100,000 or more by the time you retire.
Once you move on—whether it be to a new job, or due to layoff or a planned work hiatus—you no longer are required to keep the money in your ex-employer’s 401(k) plan. (Check out our guide to your options here .)
In fact, if your account balance is less than $5,000 your old employer will typically want to boot you from the plan. But even if you’re allowed to keep your money in the old plan, you don’t have to.
And in both scenarios you suddenly face a tantalizing option: You can cash out the account and use the money today.
That can be hard to resist. Especially when you’ve yet to build up a lot of savings and you likely have a way-too-long list of good uses for some extra cash.
According to Vanguard data from 401(k) plans it runs, about one in three accounts with values between $5,000 and $10,000 were cashed out in 2017 when the owners left a job, and 25 percent of accounts with $10,000 to $25,000 were cashed out.
But cashing out will cost you, now and down the line.
“Raiding your retirement account today to pay for other things is a bad habit,” says certified financial planner Jeffrey Levine, CEO of BluePrint Wealth Alliance. “You can’t raid your retirement accounts and then expect to have savings in retirement.”
The ability to cash out a 401(k) preys on our human nature to care a whole lot more about what we need today rather than think about what is best in the long run. There’s a term for this behavioral bad-habit: present bias.
Garrett Prom, a certified financial planner in Austin, Texas, walks clients through a quick mental calculation to ward off present bias. He uses a simple assumption that the value of a 401(k) today will double in value every 10 years. So if you have $5,000 today, it will be $10,000 in 10 years, $20,000 in 20 years and so on.
“And that’s just with one 401(k),” says Prom. “Imagine what you are doing to yourself if you cash out a few 401(k)s.”
And no account is too small to preserve; the longer you have until retirement, the more you can let compounding do a lot of the heavy lifting for you.
Talk yourself out of cashing out a $10,000 401(k) and you could have $100,000 in 35 years assuming a 7 percent annualized return. A $15,000 401(k) balance left untouched could be worth $160,000 in 35 years if you keep it invested.
You can’t expect to keep the entire value of your account when you cash out, either. The Internal Revenue Service is going to step in and grab some of that money. You will owe a 10 percent early withdrawal penalty if you are younger than 55 when you leave a job and cash out your 401(k). Been saving in a traditional 401(k)? You’ll also owe income tax on every penny you cash out. Add it all up and it’s likely that if you cash out $10,000 you’re going to pocket about $7,000 or so.
If you’ve been saving in a Roth 401(k) you will also be hit with a tax bill based on the portion of your cash out that came from earnings, not contributions. You can calculate a rough estimate of both the penalty and tax hit on a cash-out, and the opportunity cost of not leaving that money to grow.
E-Trade Financial found that 6 in 10 millennials it surveyed have raided their 401(k). Sure, in a true financial emergency—you can’t cover your rent or mortgage, for example—cashing out a 401(k) can be a rational last-resort move. But another survey of millennials who cashed out reported that more than 40 percent used the money for non-emergencies such as paying for a wedding and buying a car. Not exactly emergencies.
Even if you’re eyeing cashing out as a way to pay off current debts, Levine advises slowing down and considering the trade-off. If the debt has an interest rate that is lower than 8 percent or so—the historical average annual return for a portfolio that is 60 percent in stocks and 40 percent in bonds—cashing out doesn’t make sense, especially when you consider you will owe that 10 percent early withdrawal penalty.
If your goal is getting rid of credit card debt crushing you with an obscene interest rate, that may be worth considering. “But only if you are sure you won’t run up more credit card debt,” says Levine. And only as a last resort, if you really can’t find a way to come up with extra cash flow to pay down your credit card bills.
Leaving retirement funds growing for retirement should always be your default mode. “It can be hard to leave the money invested when you are younger and you feel like it’s not doing much for you,” says Levine. “But if you touch it now it can’t do anything for you in retirement. And that’s why you started saving in the first place.”
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