How 401(k) cash-outs hurt down the road

When you change jobs, do you take the money and run? A disturbingly-large and growing number of young and low-income workers do just that with their 401(k)s – and it’s damaging their chances of building adequate retirement savings down the road.

Data released today by Fidelity Investments shows that 35 percent of all participants in plans it administers cashed out their 401(k) balances when leaving their jobs last year, and the trend was even worse for young and lower-income workers. Four out of ten workers (41 percent) age 20 to 39 cashed out, and 51 percent of workers who left jobs grossing under $30,000 cashed out.

Fidelity has only been tracking cash-out data since 2009, but a study of the overall retirement market released last year shows an accelerating trend. HelloWallet, a firm that provides software-based financial guidance tools for employers and employees, analyzed Federal Reserve data and found that $60 billion was cashed out from workplace plans in 2010, up from $36 billion in 2004.

“The overall trend is a large and systematic increase in the rate of money coming out of 401(k) accounts for non-retirement spending,” says Matt Fellowes, HelloWallet’s CEO. The firm’s study found that 401(k) breaches were most likely to occur in low-income households living on the financial edge – that is, they had no liquid emergency savings, sometimes missed bill payments, lacked health insurance or carried credit card balances.

Cashing out – compared with leaving savings in a former employer’s plan or rolling over to an IRA – comes with major downsides. Cash-outs before age 59 ½ are subject to 10 percent penalties in most cases.

Withdrawn sums also are taxed as ordinary income; taken together, that can eat up a substantial portion of the withdrawn funds. Fidelity provides the below example.

Fidelity 401k cash-out-graphic

A 36-year old saver cashes out a $16,000 nest egg; assuming 20 percent federal and state tax withholding rates, $3,200 would be withheld by the employer, and she would be hit with another $1,600 in penalties – reducing her net withdrawal to $11,200.

Even more important, she will miss out on the compound growth that would have accrued by leaving the money in a 401(k) or IRA for the long haul. At age 67, the nest egg would be worth $87,500 in today’s dollars, Fidelity calculations show, assuming a 4.7 percent annual real return and no additional contributions (The growth calculation doesn’t include fees or taxes that would be paid on withdrawal.).