In today’s “Money Mondays” segment, Mellody Hobson talks about changing jobs and what to do with your 401(k) when making the switch.
Today I want to talk about what to do with your retirement plan when you change jobs. The first rule is NEVER EVER cash out your 401(k) plan. It seems I really can’t say this enough times because people are still doing it!
I think everyone knows that cashing out your 401(k) to do home repairs or pay for your wedding is a bad idea, but when switching jobs comes up, the money seems “up for grabs” in people’s minds. Make no mistake: It’s not! It’s for your retirement, and it’s a NEED to have, not a “nice to have.”
Young people are especially at risk. Aon Hewitt just released a report that shows more than half of workers in their 20s who have 401(k) plans cash out their holdings when they change jobs, partly because their balances are relatively low. This is compared to only about a third of those who change jobs in their 50’s. (And a third is still way too many!)
So why are young people more likely to cash out?
For starters, young adults have less money and rationalize that they need it right away. And I get it. When you’re trying to make ends meet, it’s tempting to cash out any account with dollar signs that has your name on it. But this is the thing. The penalties are SO punishing that the best mentality for everyone to take is that if it’s in your 401(k) plan, it’s not your money—yet!
When you’re say, 26 years old, retirement seems like it’s a very long way away…but that time in the market is the very reason the money has to stay put.
Say you have $10,000 in your retirement plan, and you cash it out. You’ll pay a 10% federal penalty—$1,000—for taking an early withdrawal. And because the money was put into the account pretax, you’ll have to pay that income tax— about $2,500 based on a 25% marginal tax rate. So you’re out $3,500—netting just $6,500—and maybe even less when you account for any state taxes and penalties. That’s a high price to pay to meet any short-term expenses, but the real impact comes from the longer-term, tax-deferred investment you’re missing.
Let’s say you leave that $10,000 in a tax-deferred retirement plan. Assuming a modest 6% annual return, you’d have $102,000 after 40 years. So the choice is simple: $3,500 for 26-year-old you, or $102,000 for 66-year-old you. That’s a difference of $98,500. Take that same projection over 60 years and we’re looking at over $329,000 for 86-year-old you.
If you’re young and are tempted to cash out your plan, try to imagine a little old man or lady pleading with you to leave your retirement funds intact!
So what SHOULD people do who are switching jobs?
You have a few options I’d recommend, and none of them are cashing out. First, you could leave the money in the retirement account at your old job, keeping in mind that it may be harder for you to keep track of if you have multiple accounts in different locations. Second, you could rollover your account into your new employer’s plan. Third, if your new employer doesn’t offer a plan, you could roll the money into an individual retirement account. The human resources department should be able to assist you with any of those options.
One final word of warning: If your balance is lower than $5,000, your employer may not let you keep your plan with them when you switch jobs—and they may even mail you a check for the money less 20% to pay federal taxes. Don’t cash it! You still have 60 days to put your original balance into a new retirement account until taxes and penalties apply. And don’t fret: You can recover any money that was withheld for taxes come tax time.