Too Many Americans Are Making This Retirement Mistake

The very essence of a retirement nest egg lies in the concept of patient growth and compounding of investments over time. Its purpose is to offer a bountiful reserve of funds when one bids farewell to the workforce, ensuring a comfortable retirement. However, a disconcerting trend has emerged, as a significant portion of younger workers succumb to the temptation of prematurely shattering their nest eggs.

The result is a tax bill, fines for early withdrawals, lost contributions and a diminished – or vanished – account balance likely to come up short at retirement time. We’ll discuss the details.

A financial advisor can help you organize your retirement savings and make sure you are set up to meet your financial goals.

Workers Are Cashing Out Their 401(k) When Leaving Their Jobs

According to a study from the UBC Sauder School of Business, more than 41% of workers who were leaving their jobs cashed out their employer-sponsored 401(k) retirement plans early. That’s up from the pre-pandemic level when about one of every three departing workers withdrew cash or completely emptied their accounts.

There are a number of financial problems with such a move. One of which is because contributions are tax-deferred, the withdrawals are treated as ordinary income, subject to the worker’s marginal tax rate.

In addition, the internal revenue service (IRS) takes a second cut, adding a 10% penalty for withdrawals made before age 59.5 (although there is an exception available to workers 55 and older).

If you’re ready to be matched with local advisors that can help you achieve your financial goals, get started now.

Other Financial Consequences

Workers may also sacrifice some of their 401(k) employer’s match if their account isn’t totally vested, which can take as long as four years. In addition, the worker loses out on the valuable long-term compounding for all of that untaxed money.

And workers who take loans against their 401(k) balances must repay the entire balance before the next federal tax filing deadline. If workers don’t repay the balance before then, the remaining loan balance is treated as a distribution and is treated as taxable income.

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Cashing Out Depending On the Balance

There also are situations where employers can choose to cash out your account when you leave the job, depending on the balance:

Less Than $1,000 Account Balance

The employer can cut 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 rolled over to an individual retirement account (IRA) in your name. That IRA is at least tax-deferred, so you don’t take the tax hit. The bad news is that so-called “forced-placed” IRAs can hit you with big fees that can drain your account over several years.

More Than $5,000 Balance

The employer can’t force you out of the plan. You’re free to leave the money right where it is.

In all cases, your best bet as soon as you know you’re leaving is to contact your benefits department for instructions on having your money rolled over into an IRA at an institution you choose. Any financial institution offering IRAs can handle the rollover for you.

You also may be able to roll your money directly into your new employer’s 401(k) plan, if that’s allowed. If you have received a check, you have 60 days to deposit that money in an IRA along with enough cash to cover the 20% of the balance that was withheld.

Bottom Line

Workers who cash out their 401(k) balances when they leave a job will be hit with taxes and penalties on the money immediately. And it may not have enough long-term investments to cover their retirement needs.

Tips for Getting Retirement Ready

Retirement planning is complex and can be stressful. If you’re not sure what your vision looks like, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost 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.

Social Security is another source of income you can expect during your senior years. While you shouldn’t depend on it, it can help cover smaller expenses during retirement. Find out the amount you’ll receive with our free Social Security calculator.

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