Do Your Employees Understand the Consequences of Cashing Out Their 401(k)s?

For many Americans, these are troubled times. Layoffs are increasing, costs are rising, foreclosures are becoming more commonplace, and consumers are finding it increasingly more difficult to qualify for credit. Such conditions usually give rise to an atmosphere of panic and uncertainty among the investment community. But what is particularly disturbing in today’s market is the increasing number of Americans who are going against conventional wisdom and cashing out their 401(k) accounts.

This trend is especially prevalent among young investors who find themselves in difficult financial straits for a number of reasons. A recent Fidelity investment survey revealed that a whopping 40% of 20-40 year olds cash out their 401k when leaving a job. Other common reasons for withdrawing money early from a 401k include: a down payment for a home, education expenses, mortgage payments and financing an event (such as a wedding or funeral). This is a trend that has been growing steadily even before the credit crunch and housing downturn hit full force, and it is expected to continue well into 2009 and beyond.

In light of this trend, there is cause for concern that participants are not being properly educated about the choices they have in hardship situations and the ramifications of those choices. Employers, however, can take an active role in educating their participating employees by communicating the value of their 401(k) accounts and detailing the options available when faced with the possibility of early withdrawal.

Taxes and Penalties
For most participants in a financial hardship situation, cashing out should be a last resort simply because the damage done by taxes and penalties is too great. For example, if a participant needed to get $10,000 net from his/her 401(k) due to hardship, that person would have to withdraw $17,241 – with $7,241 going to federal and state taxes and penalties based on a 25% federal tax bracket, a 7% state tax, and the 10% early withdraw penalty. Participants also fail to recognize the other “penalty” of opportunity cost, or the potential savings they lose when making an early withdrawal. Based on an 8% return, the above individual would lose an additional $97,900 in growth over the next 20 years.

Borrowing from the 401(k)
A better option may be to take a loan from the 401(k) because there are no taxes involved and the participant pays the money back into their own account. Most 401(k) loans must be paid back in full within five years, but the real pitfall is when there is a termination or change of employment. In such cases, most 401(k) plan sponsors require that the loan be paid in full within 60 days. Any amount that is not paid back would be deemed a distribution and assessed taxes and penalties (unless the participant is over 59½, in which case only taxes would apply). Usually, this option is a secondary consideration to traditional bank loans or home equity loans.

Preparing for the Worst
For those participants who are not faced with the possibility of having to raid their 401k, planning for possible hardships is probably the best option. While participants are financially healthy, experts recommend they take measures to build cash reserves (about 3-6 months worth of living expenses) and develop a budget to control spending. Securing a home equity line of credit could also protect against having to tap into retirement savings.

Let It Roll
Whenever a participant leaves his or her job, they should know the benefits to rolling over their retirement funds as opposed to cashing them out. For a 30-year-old participant in a job transition, a 401(k) worth $5,000 may not seem like much at the time, but if those funds were rolled into an IRA, left in the plan, or rolled to a new employer’s plan, they could become $50,000 when the participant reaches 60. There is also a tax advantage in that no taxes or penalties will be incurred when rolling to an IRA or to another 401k. If the participant takes it as a distribution, he or she could be left with less than $3,400 after taxes and penalties.

In today’s disturbing economic times, it is important that people become educated on financial issues that affect them – especially when it comes to their retirement. For plan participants who are faced with a decision on whether or not they should cash out their 401(k), it is critical that they understand all their options so that they can make the best decision. Isn’t that what an employer would want for its employees?

For more information on this topic, please click on the following links…

Think Twice Before Cashing Out Your 401(k)

Raiding Your 401(k): The Consequences of Cashing Out

Early 401(k) Withdrawal Costs How Much?

Caution: Don’t Cash Out that 401(k)

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Important Notice: Hill, Chesson & Woody does not engage in the practice of law, accounting, or medicine. Therefore, the contents of this communication should not be regarded as a substitute for legal, tax, or medical advice.

January 2, 2009

Hill, Chesson & Woody strives to keep our clients' group decision makers abreast of trends influencing the employee benefits market. Look for Eyes on Benefits to bring you news and information affecting you and your employees.

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