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Each month, more than 5 million private-sector employees quit, get laid off or otherwise leave a job, according to federal labor data. Among those with 401(k) plans, a recent study found, about 41 percent drain those retirement accounts upon a job separation.
Workers leaving a job often view the money in their retirement plans as a windfall, says John G. Lynch Jr., a professor at the University of Colorado’s Leeds School of Business and a coauthor of that November 2022 report. And when people perceive a pot of funds as a windfall, he says, they are more likely to cash it in.
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“No one is telling you what a terrible idea it is to take money out at this stage,” Lynch says. That includes employers, who he says rarely communicate with departing workers about the importance of preserving the savings they built up while they were there.
Before you make any hasty decisions, remember that withdrawing your hard-earned 401(k) contributions can have both short-term and long-term financial repercussions and hinder your ability to retire comfortably. Here are four reasons not to cash out your retirement plan when you leave a job, and what steps to take instead.
1. You’ll pay up front
Cashing out a retirement plan before you reach age 59½ typically means paying a 10 percent tax penalty for early withdrawal — on top of any regular income taxes you owe on the money.
Another argument for waiting: If you’re like most retirees, your income will be significantly lower than when you were working, potentially dropping you into a lower tax bracket.
“If you believe your effective income tax will be lower in retirement than it is today, an early distribution will come with a higher tax bill,” says Bennett Pardue, a partner and financial adviser with Equitable Advisors’ New Canaan Group in Connecticut.
For instance, say you have $20,000 in a 401(k) when you leave your job, you’re in the 22 percent federal tax bracket, and you live in Illinois, which has a flat state income tax of 4.95 percent. Cashing out will leave you with only $12,610, after coughing up $5,390 in taxes and the $2,000 penalty.
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