Consider this familiar scenario. You’re in your late 40s and you’ve just decided to change jobs after working ten years with a previous employer. You take a look at your 401(k) statement and realize that you’ve accumulated a decent sum – say, $15,000. Now you have a choice. Do you leave that account alone? Do you roll it over into another retirement account? Or do you decide you really need the money now, and cash it in?
For too many people, the answer lately seems to be, “Take the money now.” But financial experts agree that, unless you’re facing an actual life emergency, cashing in that 401(k) or 403(b) account prematurely is almost always an unwise decision. We recently came across a good discussion of this issue in this article from US News in which reporter Rachel Hartman paints a clear picture of the pitfalls of tapping those retirement dollars too soon. Let’s explore her reasoning.
Cash it Out or Let it Ride?
“If you lose your job and have a 401(k) through your previous company, you may have the option of cashing it out,” Hartman writes. “Sometimes employees choose to take the money instead of keeping it in a retirement account. However, before accessing the money, it pays to evaluate your reasons for the withdrawal and the financial consequences that could result from the distribution.”
Her US News article then goes on to list six specific actions you should take before you withdraw the cash too soon. We think it’s a pretty solid list. After all, once you get your hands on those dollars, Uncle Sam is likely to come knocking, as you’ll see.
Action #1: Calculate What You Will Actually Pocket
Hartman’s first step is a good one: you need an honest appraisal of the dollar amount you’ll actually realize if you take the cash. It might not be as much as you thought! “The amount you have set aside for retirement will drop significantly if you cash out,” she writes.
There are two chief reasons for this, starting with the impact on your income taxes, since the withdrawal will be considered part of your taxable income. Then there’s the extra dollars the IRS will demand as a penalty. “You’ll also have to pay a penalty of 10 percent if you are younger than 59½,” Hartman adds. “These charges will reduce what you’re able to keep.” In our hypothetical $15,000 example, the penalty and taxes could quickly slash that by $4,500 or so, depending on your tax bracket.
However, there are a few loopholes, Hartman states. “The IRS waives the penalty for certain hardships, including becoming disabled and approved disaster relief. Some plans allow for hardship withdrawals.” She recommends you talk to your plan’s administrator or the human resources department to learn the full details of a hardship withdrawal.
Action #2: Consider if the Funds Are Really Necessary
Is this withdrawal really necessary, or would the extra cash simply be nice to have? “Ask yourself if the money is needed to help cover unexpected costs, and if so, evaluate the cause,” Hartman advises
She spoke with North Carolina retirement planner Spencer Pringle, who told US News, “A financial emergency is a situation that, if not dealt with properly, can adversely affect your ability to live in your home, your health or your ability to pay for essential items.” This might include essentials such as food, daily transportation, utilities or paying off a defaulted loan. It doesn’t include a nice vacation or a fancier car.
Action #3: Consider Other Ways to Access Cash
Even if you’re going through a tough situation, take the time to make a careful calculation of the exact amount you need to cover expenses. It might turn out that a partial withdrawal will do the trick. “Even in a financial emergency, you may only require a portion of your 401(k) balance,” Pringle told Hartman. “In most situations, you can cash out the amount you need to handle the emergency and keep the remaining amount invested.”
But you also need to look at other options to gather the funds. “You might be able to refinance your mortgage or take out a loan,” says Hartman. In many cases you can even borrow against your 401(k) balance.
“Most people are unaware that some plans give them the ability to borrow money instead of claiming a hardship and surrendering the amount,” says Ron Tallou, retirement advisor in Scottsdale, Arizona. “By borrowing it, you avoid the penalties and can put it all back.” Again, you should check with the plan administrator to see what is allowed through your 401(k) and what the repayment terms would be for a loan, the article advises.
Action #4: Think About the Advantages of a Rollover
If simply leaving those funds alone when you change jobs is an option, it might be the simplest course of action, says Hartman. Many 401(k) plans allow balances to be retained even after you change employers, which still gives you the same choices of funds that you had when you worked for that firm. You can always make changes later once life settles down.
However, says Hartman, if you aren’t allowed to leave the funds with your former company – or you choose not to – then consider keeping those funds in an account that is set aside for your retirement. Generally, one planner told Hartman, you’ll be allowed to roll your existing balance into your new employer’s plan. If not, talk to a financial planner about an option called a rollover IRA. “Rolling the funds into this type of account allows the money to grow on a tax-deferred basis,” says Hartman. “You will also be able to access the funds at a later point if you need them.”
Just make certain you carefully adhere to the rules governing a rollover. If you take possession of those funds in the form of a check, you could be risking a penalty. The best option is a fund-to-fund transfer where the balance is sent electronically.
Action #5: Carefully Consider the Benefits and Consequences
The reasons to take the cash are clear, says Hartman. “Cashing out a 401(k) will enable you to have the funds right away. If you lose your job and use the money to cover living expenses until you start a new position, an early 401(k) withdrawal might help you avoid going into debt. Once your income increases again, you can get back to saving for retirement.”
But that “quick fix” of cash isn’t the whole story, because, as the article warns, the long-term consequences of cashing out can be steep. “If you cash out your 401(k) now, you’ll lose out on potential interest and earnings that would otherwise accumulate over time,” Hartman writes. “Perhaps you have $20,000 set aside. If you cash it out, you’ll forfeit a significant amount of future earnings. Keeping $20,000 in a retirement account with a 10 percent return compounded annually for 20 years could amount to more than $130,000.”
Of course, this assumes you’ve planned ahead and set some actual goals for retirement. “If you plan to maintain your current lifestyle, you’ll want to make sure you have enough saved to carry out your retirement goals,” Hartman advises. “Leaving money in the account, rather than taking it out, could help you reach those financial goals.”
Action #6: Sit Down with a Qualified Advisor
As she concludes her list, Hartman suggests the same thing we do: you probably will benefit from objective, expert advice. “Making a decision that is right for your financial situation is not always a straightforward process,” she writes. “You need to compare the urgency of your immediate needs to your ability to achieve your long-term goals.”
This might require some adjustment to boost your income, perhaps by working part time or taking on a side gig. You might also look for creative ways to cut expenses (hint: take a look at inflated cell phone plans, data plans, or streaming services). You might even need to contact creditors and negotiate better interest rates or payment terms. It all adds up.
No matter what, your choices and possibilities can seem complex. That’s why a financial planner can be your best ally. But, as Rajiv Nagaich would add, when you choose a planner, make certain he or she can help you create a financial dashboard. With that tool in place, you’ll be able to see the impact of all sorts of financial scenarios, and adjust saving, spending, and investing accordingly. Contact us and we’ll gladly refer you to a planner you can trust.
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(originally reported at https://money.usnews.com)