When you leave a company–whether or not it’s on your own terms—you might panic about what happens to your employer-sponsored retirement account. While you have a few options for handling an old 401(k), some strategies are better than others.
Recent research from Harvard Business Review found that out of 162,360 employees leaving their jobs between 2014 to 2016, 41.4% cashed out 401(k) savings on their way out. Unfortunately for those employees, cashing out is rarely the right move, and might even undermine your retirement security.
Here’s why you should never cash out your 401(k) if you can help it, and what you should do instead.
Why you shouldn’t cash out your 401(k)
It’s understandable why your instinct might be to withdraw your cash from your employer-sponsored retirement plan. You might be nervous about the market, worried about cash reserves without your old job, or confused about the rollover process in general. However, the consequences of an early withdrawal likely outweigh the perks. Experts generally advise against cashing it out for the following reasons.
Taxes, taxes, taxes
Aside from employer matching, the major perk of a 401(k) is that your savings are tax-advantaged. With an early withdrawal (aka before you’re 59½), the IRS generally requires an automatic 20% withholding for taxes. So let’s say you withdraw $10,000 from your 401(k) before you are retirement age. Already, you may only get about $8,000 of that withdrawal (before tax refunds, at least).
Additional penalty tax
On top of that 20% withholding on your early withdrawal, you’ll face a 10% tax as an early distribution penalty from the IRS. That means an addition $1,000 off that hypothetical $10,000 withdrawal, bringing your take-home down to $7,000.
Locked-in losses
You might be tempted to pull out your money when the market is down, but you’re better off remembering the big picture. And that big picture likely includes a market rebound and plenty more years of growth. Don’t sabotage yourself by locking in your losses during a dip in the market.
Rollover your 401(k) instead
Instead, you should consolidate your old 401(k) into another qualified retirement plan. The obvious advantage is maximizing your savings, having access to a broader range of investments, and the ease of having less to keep track of. Here’s our guide to finding your old 401(k) savings from previous jobs so you can maximize your retirement savings.
If you don’t have the option to rollover your old 401(k) into a new one, your next best choice is to let it grow before you opt to cash out early.
For big retirement savers, the silver lining of record-setting inflation is the record-setting cap increase for your 401(k) in 2023. And for new retirement savers, here’s our beginner’s guide to starting a 401(k).
