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401(k) nightmares: What NOT to do with retirement-plan cash

Life can bring huge expenses, planned and unplanned. Many look to their retirement accounts as a handy lifesaver to get out of an unexpected, tough financial spot — but they do so at an enormous cost.

A 2015 research study conducted by Boston Research Technologies in collaboration with Retirement Clearinghouse found that 34 percent of millennials, 34 percent of Gen Xers and 24 percent of baby boomers have cashed out at least one retirement account during their careers and that "a majority of retirement-plan cash-outs are unnecessary — a product of convenience rather than need."

CNBC.com asked advisors about some of the worst mistakes they've seen for cashing out individual retirement accounts and 401(k) plans.

Job-change cash-out. "Many millennials have a tendency to cash in their 401(k) when they change jobs," said Chris Chen, certified financial planner and wealth strategist with Insight Financial Strategists. He recalled the situation of a young man who cashed out his $50,000-plus retirement account to use, in part, on a vacation and expenses.

A costumed reveller wearing a mask depicting Munch's famous painting 'The Scream' poses near St Mark's square during the carnival on February 21, 2014 in Venice.
Gabriel Bouys | AFP | Getty Images

It's an expensive mistake, Chen said. Besides paying income tax and a withdrawal penalty, the contributor will lose the benefit of long-term compound interest and the resulting retirement income. For example, a $10,000 withdrawal at age 30 could result in $250K of lost future retirement income.

Putting it all in the company stock. "As employees, we often have the tendency to drink the corporate Kool-Aid and invest in company stock," said Chen. "It is often a bad idea, as an employee is already exposed to company risk."

When things go bad, there is often no time to react, he added, noting that someone he knows invested in company stock in his 401(k) plan.

"It grew to over $1 million over several years, and then it dropped," Chen said. "Eventually, he cashed out around $50,000."

Putting it all — or too much of it — in a money market. Many people put all their money in a money market because they don't know what to do or because they try to time the market, Chen said.

"The CEO of a tech company I know has it in a money market because he is a perpetual bear," he said. "Staying on the sidelines can easily cost several times the principal over time, and the corresponding retirement income."

"As employees, we often have the tendency to drink the corporate Kool-Aid and invest in company stock. It is often a bad idea." -Chris Chen, wealth strategist with Insight Financial Strategists

Funding a down payment. "I sometimes find that people will cash out their 401(k) [plans] to put down money for a house or a condo," Chen said. "It is a terrible idea, because it is 'expensive money' and because the person will lose badly needed retirement income."

Paying off a mortgage. Jonathan H. Swanburg, CFP and investment advisor representative with Tri-Star Group, recalled a woman who retired and decided to celebrate by using some of her retirement funds to pay off the $200,000 balance on her mortgage.

"She was horrified when she realized she owed tax on the entire amount taken out of the 401(k)," he said. "To make matters worse, since the distribution was received in the same year that she had earned income from her employment, the tax bill was at the highest marginal tax rate — a very expensive mistake."

Rolling over an inheritance. "A man who inherited a large IRA thought he could take a distribution in cash and use the 60-day rollover window to get it back into a new account with a different custodian," Swanburg said. "Sadly, the 60-day rollover rule doesn't apply to inherited IRAs, and he had to pay tax on the entire amount."

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Funding college. Chris D. Hardy, CFP and CEO of Paramount Investment Advisors, recently had a couple come in for help with a tax situation. "They were told by a college funding advisor that they needed to move the money from their IRA and buy a life insurance policy in order to lower their EFC [expected family contribution] for their daughter's college," he said.

The couple followed the insurance agent's advice — and ended up owing more than $50,000 in federal and state taxes. "Unfortunately, they do not have any other funds to pay for the tax, and when they tried to cash in the policy to pay the tax, it was only worth about $12,000," Hardy said. "Massive mistake!"

Funding a divorce. Retirement funds can get wiped out in divorce settlements, said Zaneilia Harris, CFP and president of Harris & Harris Wealth Management Group. "I had a client use his 401(k) to pay for his divorce and taxes," she said. "He was not anticipating a divorce and had no emergency fund, so he's now trying to rebuild his savings."

Giving up. Harris described another unfortunate divorce situation. "The husband had been the primary breadwinner, socking away the maximum into his 401(k)," she said. "After years of fighting and attorney fees, the wife couldn't take it anymore and gave up on getting any of those funds.

"She just walked away from it," Harris said.

— By Deborah Nason, special to CNBC.com