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Here's Why Cashing Out a 401(k) Is the Worst Money Mistake You Might Ever Make

Maurie Backman, The Motley Fool

In today's job-hopping environment, it's not uncommon to go through 10 or more employers throughout your career. But if you're going from one company to another, you may be tempted to cash out your 401(k) in the process -- and you wouldn't be alone. Nearly 6 million employees are expected to cash out their 401(k)s within eight years of leaving their employers, according to data compiled by Retirement Clearinghouse.

Still, cashing out a 401(k) is an unquestionably bad idea, pretty much no matter the circumstances. And if you make the mistake of doing just that, you could end up putting your retirement at risk.

Man smacking his own head

THAT'S RIGHT. YOU'LL BE DOING THIS IF YOU CASH OUT YOUR 401(K). IMAGE SOURCE: GETTY IMAGES.

Leave that money alone

Cashing out a 401(k) is problematic for a number of reasons, the first being that you'll get slapped with a 10% early withdrawal penalty on however much you have in your account. That's because a cash-out is considered a distribution, and unless you're already 59 1/2, you don't get to access that money without penalty. (Remember, the IRS gave you a tax break for contributing to that account, so if you don't follow the rules, you're going to lose out.) Furthermore, the money you cash out will be subject to taxes, which means you won't even get to use your balance in full. Rather, you'll owe a portion of it to your pals at the IRS.

But taxes and penalties aside, here's an even greater reason cashing out a 401(k) is a horrible idea. If you don't leave that money in a retirement plan, it won't be available to you as a senior, when you need a way to pay the bills in the absence of a steady paycheck.

During your career, you have the option to work overtime or take on a side gig when you're low on cash. But what happens when you start to run out of money in retirement? Are you really going to manage to find a part-time job in your 80s, when your energy is limited and your health is on the decline? Probably not, which means you might run out of options if you take your 401(k) money now.

Furthermore, remember that when you cash out a 401(k), you don't just lose out on that lump sum of cash in retirement; you also lose out on whatever growth it could've achieved. Let's say your 401(k) investments typically return 7% a year, on average, and that you cash out a $40,000 balance at age 45. If you're not planning to retire for another 20 years, that sum could conceivably grow to $155,000 over the course of two decades. In other words, come retirement, you won't just have less income by virtue of the sum you cashed out; you'll also lose the associated investment growth as well.

Options for your 401(k) if you leave your job

If you're moving from one employer to another and have an existing 401(k), there's absolutely no need to cash out that account. Rather, consider one of the following choices:

  • Leave your money where it is, provided you have the option to do so. It's often the case that you can keep your old 401(k) if you change jobs, but your plan administrator might require that you have a certain balance to get this option. Though leaving your money where it is generally isn't the best idea, you might consider it if you're moving from a large employer to a smaller one whose 401(k) might come with higher fees and fewer investment choices.
  • Roll your balance into an IRA. Even if you're planning to participate in your new employer's 401(k), it might still pay to roll your old plan into an IRA. IRAs frequently offer a wider range of investment choices than 401(k)s, and that's important for two reasons -- first, because it means you're more likely to find options that align with your strategy and risk tolerance, but also, because it might help you avoid some of the higher investment fees you'd typically find in a 401(k).
  • Roll your balance into your new employer's 401(k). This is a good option if you'd rather not open a separate IRA. This way, you'll have all of your savings in one place, which will make things easier to manage.

Leaving a job is no reason to cash out a 401(k). If you're moving on to another opportunity, consider one of the preceding options for your savings. This way, that cash will be waiting for you in retirement, when you need it the most.

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