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Don't Make the Retirement Saver’s Worst Mistake

Impulsively cashing out your 401(k) could cost you down the road

By Andrea Coombes | MarketWatch | March 20, 2014

(This article appeared previously on MarketWatch.com)

When you need cash, there’s nothing like the temptation sitting in your retirement account — that stash of money that becomes all-too-available when you lose or quit your job. But withdrawing those savings can leave a deep scar on your future retirement income, according to a new report.
 
A hefty 35 percent of people who left their jobs last year cashed out their retirement savings rather than keeping their money in a tax-qualified retirement account, according to a new study by Fidelity Investments of the 12.5 million participants in the 401(k) plans it administers.

(MORE: What to Do With an Old 401(k)?)

Those findings are echoed by previous studies from other sources. (Note that just 806,000, or 6.5 percent, of that total number of plan participants ended their job in the January through September period studied by Fidelity.)

Younger Workers More Likely to Cash Out
 
There’s no doubt that taking the cash is a financial necessity for some people, and it’s not surprising that the practice is more prevalent among those with lower incomes than among those who make more: 50 percent of those earning $20,000 to $30,000 cashed out in 2013, versus 13 percent of those earning $100,000 or more, according to Fidelity.
 
Younger savers are also more prone to the practice: 44 percent of those aged 20 to 29 cashed out, compared with 26 percent of those 50 to 59, the report said.
 
But anyone who doesn’t absolutely need the cash should think long and hard before grabbing that money to spend on stuff now. Generally, you’ll play income taxes and a 10 percent penalty for pulling out the money early. Plus, your long-term savings will take a hit. 

(MORE: Maybe You Shouldn't Invest In a 401(k) After All)
 
A Retirement Income Hit of Up to 67 Percent

A separate study found that people who cash out of their plan could see their retirement income reduced by anywhere from 11 percent to 67 percent. That’s according to a projection by the Employee Benefit Research Institute, for a 2011 study of more than 1.8 million workers by consulting firm Aon Hewitt. (The projection varies based on how many different jobs the worker ends up in, and whether the new plans use automatic enrollment, among other factors.)
 
The Aon Hewitt report found that a whopping 42 percent of workers who left their jobs in 2010 cashed out of their retirement plan; it was 32 percent for workers aged 50 to 64.
 
A Vanguard report in June 2013 found that 31 percent of 401(k) plan participants who left their job in 2012 cashed out at least part of their savings, up from 29 percent in 2007.

(MORE: To Tap Your IRA or Not?)
 
“Given the ongoing uncertainties in the employment market, we anticipate an increase in cash-outs in the near term, under the assumption that plan savings are sometimes used as a personal form of unemployment insurance,” the Vanguard report said.
 
Don’t Rush
 
If nothing else, when you’re leaving a job, at least take some time before making a decision relative to your retirement funds. Generally, you can let your 401(k) savings sit in your former employer’s plan.
 
“They probably shouldn’t look at touching their 401(k) from Day One. Some people go into that quickly. They may not understand all of the implications,” said Beth McHugh, vice president of market insights at Fidelity Investments.

“Keep it in the plan for now, until you can make a more thoughtful decision,” she said. “When you’re changing and advancing your career, you want to make sure you’re advancing your retirement as well, and that you’re not taking a setback every time you move to a new employer by cashing out.”
 
Your alternatives to cashing out may include keeping it in your prior employer’s retirement plan, moving it to a new employer’s plan or rolling it into an IRA.
 
Consider your options carefully: Research suggests that retirement savers are often urged to roll their money into an IRA — even when sticking with an employer plan might be better, and cheaper, for them. Read: "Beware These IRA Rollover Mistakes."
 
Andrea Coombes is a personal-finance writer and editor in San Francisco. She's on Twitter @andreacoombes.