There are a lot of mistakes people can make when it comes to 401(k) retirement savings plans, but one of the biggest — and surprisingly, the most common, say financial advisors — is cashing out early.
Many make this blunder when switching jobs, according to Shannon Eusey, president of Beacon Pointe Advisors. "Forty-five percent of people who switch jobs before [age] 59½ cash out on their retirement plans," she said.
So how to handle 401(k) balances when changing workplaces? Take a careful step-by-step approach, said Zaneilia Harris, president of Harris and Harris Wealth Management Group, who offers a five-point plan for job-switchers. First, gather all retirement plan–related paperwork; then, consult with a financial advisor "before you make any decision and before you sign any paperwork," she said.
Third, track everything. "Make sure that whatever paperwork you send ... you actually FedEx ... so that you can keep track of where this information is," said Harris, a certified financial planner.
Fourth, if transferring 401(k) funds from your former employer's plan to that of your new employer — which is what you should be doing, rather than cashing out completely — ensure that the transfer check is made out in the name of the financial institution to which it's going. "You do not want that check written out directly to you," said Harris, warning that, if it is, "you will be taxed" on the amount.
In such cases, charges will include an Internal Revenue Service penalty, ordinary income taxes and, often, a state tax penalty on the cash-out. "Right off the top, you're giving up 40 percent of your money if you cash out on your plan," said Eusey at Beacon Pointe Advisors.
Therefore, fifth on Harris' 401(k) checklist is asking your advisor and/or accountant for details on all tax consequences "so that you can protect your nest egg," she said.
What's the big deal about cashing out a 401(k) early? "You're missing out on future compounding of that wealth," said Eusey. Compounding is the phenomenon whereby you earn interest on money deposited, and then that combined deposit and interest (plus new deposits) earn further interest, and so on, exponentially growing your gains over time.
The solution? Either keep your money in a current or new 401(k), or roll it over into an individual retirement account. "Do not pull your money out of the plan, because you need that compounding in order to pay for retirement," Eusey said.