Two Dangerous Features to Avoid in Your Workplace Retirement Plan
Loans against retirement assets and cashing out when leaving a job are ill-advised
Employers that offer a retirement plan know it’s a highly valued benefit that can help retain and attract employees. Yet 401(k)s and similar plans contain two features that can undermine success. Retirement plans make it all too easy to raid your money long before retirement. When you leave a job, you can easily access your money. And when you are working, many plans allow you to take out a loan.
Both can end up costing you plenty.
The cash-out trapdoor
When you leave a job — voluntarily or not — you have options about what to do with your 401(k). If you have at least $5,000, you can typically leave it there. Or perhaps move the money into the retirement plan at your new gig. Or into a rollover IRA where it keeps compounding, tax-free, for retirement.
Or, you can make the perfectly legal yet horribly shortsighted decision to take the money in cash.
According to a research report from human resources outsourcing firm Alight , more than half of people who left a job between 2008 and 2017 and had a 401(k) balance between $5,000 and $10,000 cashed out. More than one in five people with balances between $25,000 and $50,000 cashed out.
The Employee Benefits Research Institute — the gold standard of retirement data analysis and forecasting — recently estimated that more than $92 billion was cashed out in 2015.
If you leave a job and cash out a 401(k) before age 55 you will owe a 10% early withdrawal penalty. There will also be income tax. If you cash out a traditional 401(k) you will owe income tax on every dollar you cashed out. If you cash out a Roth 401(k) a portion of your withdrawal (the earnings) will be hit with tax if you cash out before age 59 ½ and you haven’t been contributing to the account for at least five years.
The loan/withdrawal trapdoor
Most plans also allow current employees to take out a loan from their retirement account. That immediately reduces the amount of money you have compounding for your future. And if you leave the job — again, voluntarily or not — you typically have just 60 days to get the loan repaid. If you miss that tight deadline the IRS considers the loan to be in default. Once that happens, the IRS considers the money that you haven’t repaid to be a withdrawal. The same penalty and tax hit described above comes into play.
In a 2018 analysis, accounting firm Deloitte reported that nearly 40% of retirement plan participants have taken out a loan at some point. The average default rate is 10%. Deloitte did some down-in-the-weeds number crunching and estimated that based on historical trends, the impact of 401(k) loans gone bad from 2018-2028 – including the lost future earning of the money, taxes and penalties— will amount to more than $2 trillion in foregone retirement savings.
Hands off the retirement stash
The problem with 401(k) cash-outs and loans that inadvertently become withdrawals is the tremendous opportunity cost. And it can be worse the younger you are, given the power of compounding.
Let’s say you are 25 and have $10,000 saved in your workplace retirement plan. You land a new job. If you keep the money growing for retirement – either where it is, moved into your new employer’s plan if allowed, or into an IRA rollover — it will be worth $90,000 when you turn 70, assuming a 5% annualized return.
If you instead cash it out you will owe the 10% early withdrawal penalty. Right there you’re down to netting $9,000; also, there’s income tax to pay on all the withdrawal if you saved in a traditional 401(k), or on the earnings portion of your cash out if you saved in a Roth account.
Or you’re 45 and a $40,000 loan you expected to repay becomes a withdrawal when you get laid off. That $40,000 is going to be hit with the same penalty and tax, which adds to the cost of the loan that is now in default. If you had never touched the $40,000 and kept it growing for retirement, it would be worth $135,000 at age 70 assuming a 5% annualized return.
Any time you are tempted to consider a loan or cash-out of retirement savings, plug the amount you are thinking of taking out today into an investment calculator. (A web search of “investment calculator” will send you to a free tool.) Set the end date on when you expect to retire. That’s the real cost of a cash-out/withdrawal today. You sure it’s really worth it?