Why you shouldn’t cash out your 401(k) when changing jobs

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The average worker no longer spends a lifetime with a single employer. That raises a dilemma when you do leave a job: What to do with your 401(k)?

Unfortunately, The Wall Street Journal reports somewhere between 30% to 40% of people decide to cash out their savings and turn it into mad money to be spent anyway they see fit.

That’s bad for a whole host of reasons — some obvious and some not-so-obvious.

RELATED: Should you take out a loan to pay for a vacation?

Here’s why cashing out your 401(k) is a really bad idea

Tempted to spend your retirement savings down when you leave a job, instead of rolling it over to your new employer’s plan? Here’s what you need to know…

Taxes and penalties: The obvious reason you shouldn’t cash out your 401(k)

Many people have taken to raiding their retirement savings as they hop around from job to job without fully understanding the repercussions. If you do choose to cash out your 401(k), you’ll typically get hit with income taxes and a 10% penalty that can eat what amounts to an effective 40% of your money when all is said and done.

For example, if you take a 401(k) with $10,000 in it and cash it out, you get a tax and penalty bill for a combined 20% upfront. Then, when you file your tax return the following year, you get hit with another 20% or so in taxes and penalties.

That means your $10,000 becomes more like $6,000 and you have zero saved for retirement.

Want a better strategy? Leave it with the old employer’s plan or roll it over to your new employer’s plan.

But note this: If you want to do the latter, there’s a right way and a wrong way to rollover your 401(k). The right way is to do what’s called a “trustee-to-trustee transfer” when you move the money.

A trustee-to-trustee transfer means the money goes from your current plan administrator to your new plan administrator and never enters your hands.

You almost never want to receive a check for it yourself — even if you go ahead and deposit in a new retirement account — unless you want to risk being eaten alive by taxes and penalties.

Exception to the rule: Here’s when it OK to cash out your 401(k)

When might you legitimately consider cashing out your 401(k)? Only if you’ve absolutely exhausted every other resource and can’t put a roof over your head or food on your family’s table.

For example, you might meet this criteria during a period of extended unemployment. However, given the low unemployment rate right now, it’s highly unlikely that you’ll spend such a long time without a job and no means to support yourself or your family.

Meanwhile, there are some circumstances where you can withdraw retirement money and pay only tax with no penalty.

For IRA holders, these circumstances include buying a home (as a first-time homebuyer); paying educational expenses for immediate family; and some select instances involving unreimbursed medical expenses and health insurance.

When it comes to your 401(k), you can make a penalty-free early withdrawal in two circumstances: If you turn 55 or older the same year that you leave your employer, and for some unreimbursed medical expenses.

The problem is these circumstances are little understood by the average person and all too often disregarded. So be sure to consult with a tax professional before making any decision.

Opportunity cost: The not-so-obvious reason to not cash out your 401(k)

A penny saved is a penny earned, right? No, not if you cashed out all your pennies and they have no time horizon to grow into larger amounts of money!

Perhaps the biggest danger to cashing out your 401(k) is opportunity cost. Simply put, if you spend that money, it won’t be there to grow over the next 10, 25 or 50 years. You’re missing out on a lot of opportunity to build real long-term wealth.

Let’s say you have $5,000 in a 401(k) when you leave a job. If you cash it out to pay off credit card debt, buy a vehicle, pay your student loans, pay for a vacation, etc. it’s gone from your life.

The best way to illustrate this is with a chart.

Year Value of 401(k) you plan to cash out
401(k) growth if you leave the money alone—making no additional contributions
1 $5,000 $5,000
5 0 $7,346.64
10 0 $10,794.62
15 0 $15,860.85
20 0 $23,304.79
25 0 $34,242.38

Now, here’s the caveat: The numbers assume an 8% annual growth rate by investing your money in a low-cost index fund.

That may sound like a lot of growth, but consider that the S&P 500 — which a popular index tracking the financial performance of the 500 biggest U.S. companies — has seen an average annualized total return of 9.8% over the past 90 years.

Don’t like the numbers we’ve modeled here? Run your own projection using the compounding calculator at MoneyChimp.com.

The big takeaway here is if you cash out a 401(k) that’s worth $5,000 when you leave an employer, you’re robbing your future self of more than $34,000 25 years down the road!

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