The essence of a retirement nest egg lies in the concept of patient growth and compounding investments over time. Its purpose is to provide an ample reserve of funds when one retires from the workforce, ensuring a comfortable retirement. However, a disturbing trend has emerged as a significant portion of younger workers succumb to the temptation to break their nest egg prematurely.
The result is a tax bill, early withdrawal penalties, missed contributions, and a reduced – or eliminated – account balance that will likely fall short in retirement. We discuss the details.
A financial advisor can help you organize your retirement savings and ensure you are ready to achieve your financial goals.
Employees cash out their 401(k) when they leave their jobs
More than 41% of employees who left their jobs cashed out their employer-sponsored 401(k) retirement plans early, according to a study from the UBC Sauder School of Business. That’s more than pre-pandemic levels, when about one in three departing workers withdrew cash or completely emptied their accounts.
There are some financial issues with such a move. One is because the contributions are deferred and the withdrawals are treated as ordinary income, subject to the employee’s marginal tax rate.
Additionally, the Internal Revenue Service (IRS) has a second reduction, imposing a 10% penalty for withdrawals before age 59.5 (although there is an exception for workers age 55 and older).
If you’re ready to be matched with local advisors who can help you achieve your financial goals, start now.
Other financial consequences
Employees can also sacrifice a portion of their employer’s 401(k) match if their account is not fully vested, which could take up to four years. Plus, the employee loses the valuable long-term gain for all that untaxed money.
And employees who take out loans against their 401(k) balance must repay the entire balance before the next federal tax filing deadline. If employees do not repay the balance sooner, the remaining loan balance is treated as a distribution and as taxable income.
Payout depending on the balance
There are also situations where employers may choose to cash out your account when you leave the job, depending on the balance:
Account balance less than $1,000
The employer can issue you a check. But it won’t be for the full amount. The IRS requires the employer to withhold 20% to cover income taxes.
Between $1,000 and $5,000 loan balance
The accounts can be involuntarily transferred to an Individual Retirement Account (IRA) in your name. At the very least, that IRA is tax-deferred so you don’t take the tax hit. The bad news is that so-called “force-placed” IRAs can hit you with big fees that can drain your account over several years.
Balance over $5,000
The employer cannot force you out of the plan. You are free to leave the money where it is.
In all cases, as soon as you know you are leaving, it is best to contact your benefits department for instructions on having your money transferred to an IRA at an institution of your choice. Any financial institution that offers IRAs can handle the rollover for you.
You may also be able to deposit your money directly into your new employer’s 401(k) plan, if that is allowed. If you received a check, you have 60 days to deposit that money into an IRA, along with enough cash to cover the 20% of the withheld balance.
A financial advisor can help you understand the tax implications of your retirement accounts and how to best manage them. Make a match with a financial advisor today.
In short
Employees who cash out their 401(k) balances when they leave their jobs will immediately be hit with taxes and penalties on the money. And the country may not have sufficient long-term investments to meet their retirement needs.
Tips to prepare for your retirement
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Retirement planning is complex and can be stressful. If you’re not sure what your vision looks like, consider talking to a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Social Security is another source of income you can expect to receive during your senior years. While you shouldn’t depend on it, it can help you cover smaller expenses during your retirement. Find out the amount you will receive with our free Social Security calculator.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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The post Alarming Number of Working Americans Cashing Out Retirement Bills When Changing Jobs appeared first on SmartAsset Blog.
