Avoid Cashing Out Your 401(k)

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By JLP | July 13, 2008

Check out this quote from a recent Wall Street Journal article by Andrea Coombes:

…about 40% of workers in their 20s and 30s said they had cashed out their 401(k)s or 403(b)s when they switched jobs, according to an online survey of about 1,200 people conducted in January for Fidelity Investments by CMI, a research firm.

Quiz time:

You quit your job and take a new job with a different company. You have $800 in your old company’s 401(k) plan (you had just started contributing). Do you:

1. Move the money to your new company’s 401(k) plan?
2. Move it to an IRA?
3. Cash it out because it’s such a small amount of money?

Of course options 1 and 2 are the best. Number 3 is the worst. But, how bad is it?

Well, for starters, your employer will have to withhold 20% of your $800 for income taxes. You will also lose another 10% due to the IRS’s early withdrawal penalty. So, your $800 becomes $560 by the time you actually receive it.

Now, what’s the opportunity cost for cashing out your 401(k)? As you can see from the following graphic, it can be a significant amount over a long period of time:

The Opportunity Cost of Cashing Out a 401(k)

Don’t underestimate the potential growth of a small amount of money! Instead of looking at $800 as a small amount of money now, consider it’s future value if invested properly. And, if there’s ever a time when you are tempted to cash out your 401(k) in order to pay bills, fix your car, or take a vacation, PLEASE re-read this post!

Topics: 401(k), IRAs, Investing, Retirement Planning, Time Value of Money |

Comments to “Avoid Cashing Out Your 401(k)”

Jeremy Says:
July 13th, 2008 at 2:41 pm

It is frustrating how often I see people do this. Every week I have at least one or two people come in and say they NEED their 401k money now that they are leaving. I can show them the money they will lose with taxes and early withdrawal penalties, or how the compound interest on that little bit of money would add up, but I’d say 90% of the time they are so convinced that they need the money that they will take it no matter what.

It’s even worse when I see older people in their 40s and 50s do this. They may have saved up a decent amount of money, and end up cashing it out so they can pay off credit cards or blow it on home renovations or something.

Oh well, I hope those people enjoy working until the day that they die or end up living in poverty through retirement.

Wilson Says:
July 13th, 2008 at 7:12 pm

one should cash out a significant portion of the 401k to avoid losing all of value. Indy MAC is just the beginning. More financial institutions will fail, leaving FDIC unable to insure all of the value…

JLP Says:
July 13th, 2008 at 7:42 pm

Wilson,

I’m sorry but that’s bad advice. Sure, you may be right and the market will drop further. However, trying to time the market is no different than going to Vegas. Bad advice.

Sam Says:
July 13th, 2008 at 9:10 pm

Educating them the cons and pros of cashing out their 401k money will probably help them reconsider their options.Agree, “small” amount of money often grows into huge amount due to compounding of interest.

Was surprised somebody suggested moving significant portion of their 401k due to fear..bad..

Preston Says:
July 13th, 2008 at 9:40 pm

Again, there isn’t a be-all-end-all answer to this. I recently cashed out a 457 when I switched jobs because the company wouldn’t allow me to keep it in the account because it was under $5000. All options had pros and cons. Although with that $1000 I got back I squirrled it away in a savings account and it has gained 4% (APY) over the past 4 months. If I had rolled it into the funds I considered for an IRA, it would be down 16%.

Wilson Says:
July 13th, 2008 at 9:41 pm

JLP: 401K is a modern scam. I’m in no position to count on it for my retirement, as most 401k plans allow long positions only. The sheeple who listened to their financial advisers’ 8%-annualized-return pitch at the top of the market deserve their financial destruction. If I were you, I’d feel embarrassed being unable to time the market after sixteen years of practice in the financial sector:)
Three simple tips for your profit in the long and mid term:
A) look at the weekly 89SMA of S&P 500. If S&P closes on a Friday above it, bull market may resume. Until then, it’s a secular bear market.
B) look at daily 13,34,89SMA of the chart of the underlying to figure out the mid term trend. These are all fibonacci numbers. While people use fibo ratios on the price, the ratios could be used on the time element as well.
C) look at the 10 and 21day EMA of the CBOE equity only put/call ratio: rising==bear, dropping=bull.

Follow my advice and you’d make some good money. I’ve been doing it part-time on stocks since late May and two of my CASH accounts are up 30+%, with stock transaction fees at $19.95 for my Fidelity account and $24.95 for my JPMorgan brokerage account. Who says one couldn’t time the market? If I were a full time trader, I wouldn’t be surprised to double my account value every year. Of course, I’ve been doing exceptionally well on my engineering profession and don’t have to be a trader for the time being. Since you are in the financial business, I’d like to pass my experience to you and your readers. Never say you don’t have an edge over the market, unless you are dumbed down like the average American sheeple.

"Mo" Money Says:
July 14th, 2008 at 9:50 am

Cashing out your 401k is absolutely the worst thing to do. That money can never be replaced, and since time is an improtant ingredient in building wealth and working on your retirement, don’t do it. You could replace the money, but the time is gone forever.

Percy Says:
July 14th, 2008 at 10:52 am

Actually option 2 is better than option 1. Moving it to an IRA opens up the full spectrum of investments offered by a broker. Moving it to a company 401K has limited investment opportunities.

Jenna Says:
July 14th, 2008 at 11:11 am

This is an excellent point. I think its actually normal for most people to just cash their 401(k) out when they change jobs, and that is sad…

I’d love to see a quick explanation of the rollover process?

Foobarista Says:
July 14th, 2008 at 12:29 pm

There’s a difference between what to do with a rollover and the details of the investments. Cashing out is pretty much never a wise option.

You can always roll it over into a self-directed IRA. IRAs can be invested in anything that non-IRAs can be, including stock shorting, gold bars, CDs, etc. You can even invest your IRA in an LLC, take the LLC money to Vegas, and put it all on Red if that’s your thing.

Philip Says:
July 14th, 2008 at 3:36 pm

You are not comparing all the numbers equally. You will still have to pay taxes on that withdrawl when you retire, not the penalty though. So your 35/45 year numbers would be reduced significantly if you are comparing what you can have now from the $800 to $560.

JCH Says:
July 14th, 2008 at 6:15 pm

Wilson, you should quit your engineering job and become a fulltime trader. even with $1000, you can have a million in 10 years, a billion in 20 years, a trillion in 30 years. As an engineer, there is no way to make that kind of money.

muddlehead Says:
July 15th, 2008 at 9:24 am

wilson, don’t have kids.

Richard Says:
July 15th, 2008 at 11:41 am

JLP:

Your advice against timing the market is probably good advice for those who don’t have a clue about financial matters. But it doesn’t take a genius to figure out that buy-and-hold can be a losing proposition. And if you say, “well, you should know your stocks and sell them if they don’t meet your original criteria”–then I consider that just another form of timing. However, usually by the time you figure out your stock doesn’t meet your criteria, it has probably lost a good portion of it’s value. Let’s face it, companies are going to do everything in their power to disguise their problems as long as they can.

I have had considerable success timing the market, both short, intermediate and long term. The typical advice that it can’t be done is just simply wrong and probably bad advice. It’s bad advice because it can be learned and telling people it can’t be done discourages the uninitiated from even trying.

Most people don’t want to get involved with managing their money, but they will ultimately pay a very high price for that–like working many more years than necessary. Yet if they were to just take a few minutes a week to look at a chart of, let’s say the S&P or NDX, they could avoid many of the pitfalls the market presents.

Here is a very simple way (by no means the only way) to “time” the market that will suit many individuals who don’t want to spend much time at it:

l) Invest only in an ETF or index representing a broad portion of the market. (Example, the QLD, which represents the NDX-100 technology sector times 2.)

2) Be invested in that ETF as long as the NDX-100 index remains above it’s 200 day moving average.

3) Sell the ETF and go into a Money Market fund or cash when the index falls below that 200 day moving average.

Check this moving average at least once a week and take action as necessary. This is the absolute minimum you can do in the form of timing. It will keep you in the market in most of the good times and out of the market during most of the bad times. (Using the index in the above example, QLD responds to the NDX-100 index times 2; e.g., if the market goes up 1%, QLD will go up 2%–and vice versa on the downside. A more conservative approach is to use the QQQQ ETF.)

Dick

Richard Says:
July 15th, 2008 at 12:38 pm

My previous memo does not refer to 401k’s because you don’t have the flexibility to trade ETFs in most plans I’m aware of. Depending on how fast your 401k responds to your Buy or Sell orders, you can still use the moving average to determine whenby using to be long the market or in Money Market. Use mutual funds that represent a large portion of the market and track it on a chart of the index that most closely represents your mutual fund. Alternatively, you can actually use the mutual fund itself to track the moving average, taking action on price crossovers.

Dick

rbk Says:
July 15th, 2008 at 1:36 pm

Beware Richard’s advice. He tosses that scheme out there like it’s a sure thing to beat buy and hold. I did one simple example using a random start date (Feb 15 2006) and the conservative strategy he suggests (QQQQ and 200 day moving average). BEFORE transaction costs, his scheme would have you up 6.2%, having cashed out a few weeks ago and not yet bought back in. Buy and hold would have you still in QQQQ with a gain of 7.5%, and that includes the nearly 9% dive in the last 3 weeks. Add the transaction costs of more than a dozen trades and buy and hold wins by an even more comfortable margin.

Might his strategy work sometimes? Yes, it might. But I suggest you do some research because it’s pretty easy to see that it won’t always treat you so well.

Richard Says:
July 15th, 2008 at 4:23 pm

rbk:

What are the results for the same period for the QLD?

By the way, where is your protection if we go into a long term bear market–one that lasts for several years. We’ve been in a secular bull market for several years, where buy-and-hold can work. If you can live with risking your future on the bull market continuing–go for it. But you are essentially handing your future off to fate. My method at least gives you some control over your fate. If you don’t think we can’t go into a bear market for any length of time, run your tests back to the 1930’s and 1970’s.

Dick

Richard Says:
July 15th, 2008 at 5:29 pm

One more thing, many buy-and-holders usually give up on their positions at some point where they can no longer bear the pain of a major decline. That point is usually somewhere near the bottom. Then the paralysis of fear keeps them out until the new bull phase is well underway. Very few buy-and-holders are able to cope with a major bear. I’m merely trying to give people the simplest way I know to weather the market’s storms with the least amount of pain. I’m trying to give them a little more control of their future with a method to reduce the risk of investing in the market.

I don’t know if we are going to continue this bear phase of the market or if a bull phase will soon return. Anyone who tells you they know–run like hell.
But I do know that moving averages will keep you on the right side of the market.

mike Says:
October 5th, 2008 at 5:11 pm

I am getting a vested amount of $95,000.00 after April of 2009. Is there something I can invest in that will earn me $3000 to $5000 per month?

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Avoid Cashing Out Your 401(k)