The Costly Mistake One-Third of Americans Make With Their 401(k) When Changing Jobs

Americans are changing jobs more than ever, and one-third of them cash out their 401(k) retirement plans in the process, according to research from Vanguard. While cashing out a 401(k) may seem like the least stressful choice during a hectic job change, it has far-reaching consequences. The drawbacks can include higher taxes, penalties, and lost investment income.

Here's more information about why many employees cash out their 401(k)s early, as well as some other options people can consider if they are planning to switch employers in the future and have a 401(k) plan to manage.

Why do employees cash out their 401(k)s when leaving jobs

Employees cash out their 401(k)s when leaving a job for many reasons. Some may feel that rolling over a 401(k) into a new one or an IRA is too burdensome. Others might not realize the penalties that will occur when they make an early withdrawal. Finally, some employees have smaller balances, and they may not feel like it's worthwhile to move it. If employees are laid off, they may also need the lump sum to cover unexpected emergency expenses.

Ultimately, a lack of knowledge, financial burdens, and the stress of changing jobs can all contribute to this decision.

The high cost of early withdrawal in taxes and penalties

When workers withdraw their 401(k) money, there is a 10% early withdrawal penalty for those who are under age 59 and a half. Additionally, people have to pay ordinary income taxes on the full withdrawal amount, which could lead them to be in a higher tax bracket at income tax time. These fees, penalties, and tax obligations can significantly reduce the amount of money people receive when taking a lump-sum withdrawal. For those reasons, it may not even be worthwhile to some who may be expecting a larger payout.

The biggest financial damage is long-term losses

Although there are penalties and potential tax complications from taking an early withdrawal, the biggest financial cost is the one that's hardest to measure. That is the lost years of compounding interest that employees would've had had they not taken money out. Once workers take an early 401(k) withdrawal, that money is no longer compounding and growing, which can have a significant long-term impact.

In fact, Vanguard data found that even a 1% reduction in contribution rates when changing jobs could amount to as much as $300,000 less by the time workers retire. As evidenced, these decisions, which seem small in the moment, can have an outsized impact once workers reach retirement.

Workers without salaries or savings are disproportionately affected

According to Vanguard, hourly-wage workers are more likely to experience income instability, with wages that can swing up or down by 15%. A large percentage, 42%, of hourly workers cash out their 401(k)s after a job change, compared with 21% of salaried workers, and those with less than $2,000 in emergency savings are significantly more likely to make an early withdrawal.

Alternatives to cashing out a 401(k) early

Ideally, having an emergency savings account is one of the best ways to insulate against the temptation to cash out a 401(k) early. Workers with a cash cushion are less likely to need a lump sum, making them more likely to roll over a 401(k) into a new plan. Another option is to roll over a 401(k) into a self-directed IRA or leave it where it is. However, leaving a 401(k) with a previous employer means workers will need to keep track of their old job's paperwork and ensure they keep access to their accounts.

Rushing decisions under stress can be costly

Ultimately, cashing out a 401(k) after leaving a job typically happens when employees are stressed and making quick decisions. However, choosing to cash out before evaluating other options can be a costly mistake, not only in penalties but also in potential investment losses.

What to do with a 401(k) before leaving a job

Before switching to a new employer, take the time to research whether or not your new employer allows direct 401(k) rollovers. If not, consider opening an IRA before switching jobs, so you can quickly initiate a rollover without risking early withdrawal penalties. For those who have questions about the process or aren't sure what route to take, consulting with a financial planner can help ensure workers are on the right track.

Bottom line

Minimizing early 401(k) withdrawals can help workers build a nest egg and enjoy a stress-free retirement in the future. Though it may be tempting to cash out a 401(k), especially during busy times like switching jobs, the best way to build retirement savings is by steadily and consistently investing over the course of a career.

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