What’s at stake if you cash out your 401(k) early?
The UBC study used a data set of 162,360 terminated employee contribution records from 28 employers and 28 retirement plans.
Of the 41.4% of workers who withdrew their retirement savings, about 85% drained their accounts completely — with 64% taking a one-time total cashout and 21% depleting their 401(k) balances in two or more withdrawals within eight months.
Cashing out your 401(k) early is problematic for multiple reasons: you’ll have to pay taxes and penalties, you’ll lose out on the benefits of compound interest and, ultimately, you may not save enough money to retire.
It also creates a larger systemic issue, UBC Sauder associate professor Yanwen Wang said in a news release. That’s because 401(k) contributions from the currently employed are used to fund the withdrawals of retired workers. When those funds “leak” out of the system, it jeopardizes everyone’s retirement security.
To discourage people from cashing out before the legal age of 59.5 years old, the Internal Revenue Service imposes a 10% penalty for what they call “pre-retirement leakage.”
The three main sources of leakage are defaults on loans from retirement accounts, hardship and non-hardship withdrawals during active employment and cash distribution upon job termination, researchers say.
Why are Americans withdrawing their retirement funds?
So if it’s not a matter of need, what’s driving the leakage now? The experts behind the study suggest that when people quit their jobs, the money in their 401(k) transforms from a “perceptually illiquid source of long-term retirement security into a psychologically liquid pile of cash.”
In other words, your hard-earned retirement savings turn into a tempting windfall fund that’s easy to spend — especially if you’re currently job hunting and without a source of stable income.
The study shows that this mentality often shines through when employers offer generous 401(k) matching programs, helping employees to substantially grow their retirement funds.
“For example, if the employer does a one-to-two match, where for every $1 you contribute your employer will match $2, it can change the psychological sense of ownership of those 401(k) accounts,” said Wang, who co-authored the study with Muxin Zhai of Texas State University and John G. Lynch, Jr. of the University of Colorado.
“So instead of your own saved money, it’s like a windfall. And then it feels more touchable, and more legitimate to spend it when you change jobs.”
What should you do instead of cashing out?
Many Americans will work a number of different jobs throughout their lives, but that doesn’t mean you have to cash out your 401(k) every time you make a move. You can keep the money in your employer’s plan, or you can transfer your assets to your new employer’s plan.
Alternatively, you can roll your balance to an individual retirement account (IRA) where you can continue growing your retirement savings tax free until you make withdrawals in retirement.
IRAs are playing an increasingly important role in helping Americans save for retirement, especially as workers now change jobs more frequently over the span of their careers.
More than four in 10 U.S. households had IRAs in mid-2022, according to a recent Investment Company Institute study. With $11.7 trillion in assets, IRAs represented 34% of U.S. total retirement market assets, compared with 24% two decades ago and 18% three decades ago.
However, Americans still need more education on the benefits of 401(k) rollovers and the consequences of cashing out, according to Wang.
“If there is no assistance for quitting employees, there’s an unintended nudging for people to take the money out, especially if there is a large match,” says Wang.
“Something has to be done — not to control people’s 401(k)s, but to provide enough knowledge so they’re aware of the consequences of their actions.”
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