Beware of cashing out a 401(k)

Evaluate all of your options before cashing out a 401(k).

Have you ever cashed out your 401(k) when changing jobs? If so, you may have been stunned to find an incredibly shrunken balance, the victim of taxes and early withdrawal penalties that can approach 50% for people in the top income tax bracket.

All too often, people make that painful mistake when managing their 401(k) savings—they cash out. Fidelity data finds that 1 in 3 investors has cashed out of their 401(k) before reaching age 59½, often when changing jobs.

For many, cashing out a 401(k) seems like a relatively easy way to solve a short-term cash crunch, whether it's due to temporary cash-flow problems created by the loss of a job, or simply paying down a credit card or covering an emergency home repair. But while doing so may not seem like a big deal, especially if you have a small balance, over a long period of time, the consequences of cashing out can be significant.

"Once you withdraw those savings, they’re gone—and they can be very difficult to replace," says Ken Hevert, Fidelity senior vice president of retirement products. "While it can be pretty tempting to cash out your 401(k) and use the money to pay off a car or your credit card bill, you may want to think twice before doing so, and weigh the impact of that decision."

The power of tax-advantaged accounts such as 401(k)s is that they allow contributions to be made pretax and allow for tax-deferred compounding (in the case of traditional 401(k)s) or for Roth accounts, they allow tax-exempt compounding and withdrawals. In either case, your contributions have the potential to compound without taxes eroding that growth. Over time, earnings can generate their own earnings, helping you accumulate more money than you would in an ordinary taxable account.

Younger investors who cash out lose that opportunity, potentially setting their retirement savings back considerably. The average cash-out amount for those changing jobs under age 40 is $14,300, according to a Fidelity study on 401(k) participants.

Older 401(k) investors who choose to cash out may be eliminating a key part of their retirement income picture. The older a 401(k) investor is when withdrawing assets—and therefore subjecting those assets to taxes and potential penalties—the less likely they may be to generate a sustainable income in a retirement that could last 25 years or more. Older investors may have higher balances with larger tax liabilities, plus they may have fewer years to recover their savings before retirement.

If you've run into financial trouble and need money, and have no other recourse, consider taking a loan from your 401(k) if your plan allows it. A 401(k) loan will let you pay yourself back with interest, plus you get to avoid paying taxes and penalties.

If you're able to keep up your saving while you pay the loan back, the impact on your retirement may be relatively minimal—especially compared to cashing out.

A hardship withdrawal may be an option as well if it's allowed by your plan. A withdrawal will be subject to taxes and may be subject to the 10% penalty unless you qualify for an exception.

Read Viewpoints on Hardship withdrawals: what you need to know

There also is an immediate cost to cashing out. For one, it can generate a large tax bill. Your plan administrator is typically required to automatically withhold 20% of your withdrawal and send it directly to the IRS to cover the taxes you may need to pay on that withdrawal. "That means you just gave the IRS a huge chunk of the money you've been saving for years," says Hevert. "That's money you're no longer saving for retirement."

In addition to federal and state income tax, investors younger than 59½ who cash out have to pay a 10% early withdrawal penalty.

Fortunately, there are easy alternatives to liquidating your 401(k) that keep your savings intact—and, potentially, growing. If you've left a job and are considering what to do with your 401(k), here are the options:

A traditional IRA rollover. In both traditional 401(k) and IRA accounts, contributions and earnings can grow tax free until you begin making withdrawals, when you'll pay income tax on those distributions.

The rollover process is relatively easy—but every plan has different rules and the process can vary. Be sure to request a direct rollover, whereby a check is made payable directly to your IRA provider. "The benefit of a direct rollover is that taxes will not be withheld," says Hevert.

You can also choose to do an indirect rollover, in which a check is made payable to you. However, in this case it's up to you to make sure the money finds its way to a tax-advantaged account such as a traditional or Roth IRA. When you cash out your plan in an indirect rollover, your 401(k) administrator may withhold 20% of your account balance. You may need to come up with that 20% out of your own pocket to put the full amount of your 401(k) balance into your IRA. Otherwise, the IRS may categorize the difference between your plan balance and your rollover contribution as a withdrawal—even though they actually have possession of that money in the form of withholding.

This process can be complicated, and any missteps may trigger penalties and taxes. For example, if you don’t deposit the money into a tax-advantaged account within 60 days, it may be taxed as a withdrawal. "With an indirect rollover, it's up to you to prove at tax time that you did everything right," says Hevert. "With a direct rollover, you don’t have to deal with that."

A Roth IRA rollover. You may choose to roll your 401(k) directly into a Roth IRA to take advantage of the tax-free growth and withdrawals offered by these accounts. That move may trigger a sizable tax bill. You'll generally owe taxes on the 401(k) amount you convert to a Roth if you made only pretax contributions to the 401(k).

Say you have $100,000 in a 401(k). Rolling the money into a Roth IRA may lead to a tax bill of up to $25,000 if you’re in the 25% tax bracket. In that case, it's a good idea to pay the tax out of your own savings rather than dipping into your tax-advantaged retirement savings. "After all, you want to keep as much of your retirement savings intact as possible," says Hevert.

A Roth conversion may make sense for people who expect to face higher taxes in retirement. But there are other factors to consider, such as the other accounts you hold and your individual retirement goals. Consider meeting with a financial advisor or your tax professional to discuss the short- and long-term pros and cons of rolling your 401(k) savings into a Roth IRA.

Stick with a 401(k). Leaving a former employer doesn't necessarily mean you have to leave that company's retirement plan. Many plans allow former employees to leave their 401(k) account active even after they leave the company.

Keep in mind that you won't be able to make new contributions to that plan or benefit from any employer matches. But your money will still enjoy the tax-deferred growth in that plan and you'll be able to keep your investments. Check with your plan administrator to learn more about the rules, fees, and expenses. For example, many plans require that accounts smaller than $5,000 be cashed out or rolled over.

Another option is to roll your old plan balance into your new employer's plan. Doing so can make it easier to keep track of your retirement savings. Before choosing this option, review your new plan's fees, expenses, and investment options and compare them with your old plan and those in an IRA.

Here are some of the factors to consider when deciding whether to keep your savings in a 401(k) or roll the funds into an IRA.

If you decide to leave money in your old 401(k), make sure you keep your personal records—from beneficiaries to contact information—updated with the plan administrator. "You want to make sure you don't leave your money there and forget about it," says Hevert.

Whether you choose to move your old 401(k) to an IRA or a new 401(k), or just keep it in your old plan, the key is keeping your savings intact and benefiting from the tax-advantaged growth these plans allow. It might be tempting to withdraw some money now, but beware of cashing out your 401(k). You'll avoid the early withdrawal penalty and potentially have much more savings for your retirement. If you leave your money in your 401(k) until retirement, you'll avoid early withdrawal penalties and potentially have much more savings accumulated by the time you need to start using your 401(k) for retirement income.