Job Change? The One 401(k) Decision That Will Wreck Your Retirement
Ugly math: How a $10,000 withdrawal at age 30 leaves you $108,000 poorer
When you move on to a new job, you have an important retirement decision to make. If you had a workplace retirement plan, such as a 401(k), at your old job, you must decide what to do with that account. About one-third of job hoppers in their 20s, 30s and 40s make a decision that can wreck their retirement: They cash out the money.
When you leave a job, you typically have a few options for what to do with your 401(k) savings:
Leave it behind. If your account value is at least $5,000, you can leave the account with your old employer. You won’t be able to make any new contributions, but your savings can stay put and continue to grow.
Move the account to your new employer’s plan. Some employers will let you bring your 401(k) assets with you, which is called a 401(k) rollover, transferring your money into their plan.
Move the money to a rollover IRA. You can make a tax-free transfer that sends your 401(k) money to an IRA account you have at a discount brokerage.
Cash out the money. This is indeed an option. You can cash out all of the money or just a portion of it.
The high opportunity cost of a 401(k) cash-out
There are plenty of reasons – and temptations – that can make cashing out seem compelling. Maybe you’re determined to wipe out some high-rate credit card debt, or take a much-needed vacation before you start your new job, or buy a new car to go with the new gig.
The first problem with this move is the tax hit. If you cash out a traditional 401(k), you will owe income tax on the withdrawal. And if you are younger than 55 when you cash out, there will also be a 10% early withdrawal penalty.
But the bigger issue is that you’ve reduced your retirement savings. By a lot more than the amount you withdraw. An academic study estimated that cashing out can reduce eventual retirement wealth by around 20%.
That’s because when you cash out today, you’re giving up years when that money could continue to grow tax-deferred.
For example, let’s say you are 30 and land a great new job. You have $50,000 saved up in the 401(k) at your old employer. You decide to cash out $10,000, but feel good that you are leaving the other $40,000 to keep growing. That’s going to be a very costly decision.
The $40,000 will grow to $427,000 by age 65 assuming an annualized return of 7%. But if you had kept all $50,000 working for you, it would be worth nearly $535,000. That’s not a typo. Your seemingly “small” cash-out of $10,000 ends up costing you more than $100,000 in retirement wealth.
And remember, if you cash out $10,000, you’re not going to pocket $10,000. The 10% early withdrawal penalty cuts it to $9,000 and then you’ve got the income tax to contend with. Let’s assume that eats up another 20%, so you’re left with $7,000 on a $10,000 cash-out.
The next time you job hop and are considering a cash-out, slow down and consider the potential six-figure opportunity cost of making that move. Keep the money growing for your retirement, and your future self will be very grateful.