You've probably heard this advice before -- that it's generally not smart to cash out your 401(k) account when you switch jobs. It's easy, yes, to tell your soon-to-be-former employer to just cut you a check. But it can really cost you.
To find out just how costly cashing out can be, you have to consider several factors:
Unfortunately, the biggest hit for those who decide to cash out comes from tax and penalties. The penalties alone are generally a whopping 10% of your account's balance! And the taxes can be 30% or more, depending on your bracket. In contrast, you can earn a lot more by rolling over the account into an IRA and leaving it to grow.
See for yourself
Here's an example: Let's say I'm 45, plan to retire at 65, have $50,000 in my 401(k) plan, and expect to earn 8% over the long haul:
Whoa! Where did that $233,000 come from? Well, it reflects what that $50,000 will grow to if you roll it over.
It's not quite a fair comparison, though. Because you get the $30,000 now, and the $233,000 in 20 years. You may well be planning to invest that $30,000 for 20 years.
But get this: Say you do invest that money, and you earn even more than you expected -- let's say 10% instead of the 8%. You still end up with only $202,000. That's less than what you'd have by rolling over, despite the extra return.
Maximize your odds
Fine, you say. I'll just earn enough to turn my $30,000 into $233,000. Well, an average annual gain of 11% would do it, but that's easier said than done. You can invest in big names that you know well and still get mixed results. Check out these numbers:
Company
20-year average annual return
Limited Brands (NYSE: LTD)
4.7%
Pitney Bowes (NYSE: PBI)
6.6%
American Express (NYSE: AXP)
6.7%
General Electric (NYSE: GE)
9.2%
Schlumberger (NYSE: SLB)
10.6%
General Mills (NYSE: GIS)
13.4%
EMC (NYSE: EMC)
24.5%
Source: Yahoo! Finance.
The overall stock market has averaged just 10% over many decades, and over the past decade, it has actually lost ground. So why set yourself up to face a higher hurdle than you have to?
In perspective
If you're tempted to cash out your 401(k) today, stop and give a thought to tomorrow. You might reap $30,000 today, which could buy you a new car or help you pay off some of your debt, but it will also rob you of some critical income in retirement. According to our Rule Your Retirement newsletter service, in order to make your nest egg last, you should conservatively plan to withdraw about 4% of it per year in retirement. So, 4% of $233,000 would be more than $9,000 per year -- for the entire span of your retirement.
If you're like to set yourself up for an unpainful retirement, try our Rule Your Retirement newsletter service for free, with full access to all past issues. It regularly offers recommendations of promising stocks and mutual funds, too.
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