I recently came across the study from the UBC Sauder School of Business titled ‘Cashing Out Your Retirement Savings at Job Separation” and there was some surprising figures in there. In this study done from 2014 to 2016, it turns out over 41% of people when they left their job (whether it was voluntary or involuntary) cashed out their 401(k) plans. And, 90% of those (or roughly 36% of people) cashed out their 401(k) plan in its entirety. Now, this is looking at 2014 through 2016, so we’re not even talking about the impact of the COVID pandemic and everything afterwards. The study doesn’t go into why these people cashed out their 401(k) plans – it could have been that they lost their job and they needed cash to live on, could have been paying for medical debt, it could have been changing jobs and just taking a big vacation. We don’t really know, so I’m not here to say that they did the right or the wrong thing, but I do think this study shines the light on that there may be some misconceptions about what your options are when you leave your employer. So, I think it’s important for us to understand what those options are and what the impacts of those decisions might be.
The first choice when you leave your employer, whether you get fired or it’s your choice, the first choice is you can cash out that 401(k) plan. The downside of cashing that out is you don’t have the funds there to grow for retirement. There is also a 10% tax penalty for anybody who is under age 59 1/2 and those funds when they get pulled out of a retirement plan are seen as ordinary income. For example, if you have $50,000 in your 401(k) and you left to go work somewhere else and you cash that out this year, not only do you get the 10% penalty which would be $5,000 of tax, you also get that seen as ordinary income, which means it looks like you got a $50,000 paycheck in this year. Those are two things that are really important to understand because if you just cash it out and you don’t know that, you could be in for quite a headache come tax time.
The second option is (most of the time) you can just leave those funds in that 401(k) plan. A lot of times, employers are not going to require you to do anything with that 401(k) unless the balance is below $5,000 or 10,000. So, you can leave it there and let it continue to stay tax deferred, let it stay invested, and continue to grow.
The third option is if you go to a new job, a lot of times 401(k)’s will let you roll an old 401(k) into that new 401(k) plan. There is no taxable event there, it continues to stay invested just as it was prior. You can also roll it into your own IRA – so you set up an Individual Retirement Account (IRA) in your name and you can roll the funds into that as well, and it works the same way. There’s no tax impact on a rollover, there’s no penalties, nothing like that – it continues to stay invested for retirement and do what you initially wanted it to do. So, there are three choices (there are more caveats that go with some of these things, but in all reality there’s three that typically work for most people) and really it’s just important to understand what each of the differences are and what some of the impacts are. That way if you have a job change or if you have a job loss, you can make a better decision and have that decision do what you intended it to do for you and not get shocked when it comes to tax time, because having that extra income and that tax penalty can be a huge burden come April 15th! So, just understand what your options are, that way you feel better about the choices that you’re making. Y’all have a good one!
- Link to study can be found here: Americans are cashing out their retirement savings at an alarming rate: study | UBC Sauder School of Business