Study Indicates that 40 Percent of Americans Cash Out Their 401(k)s When They Switch Jobs

Transcript of Podcast Episode 233

Hello, this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, a surprising statistic. More than 40 percent of Americans take cash out of their 401(k)s when they change jobs.

The traditional 401(k) is one of America’s most basic retirement tools. Through the use of forced savings, and often, an employer match, the 401(k) helps millions of Americans save significant amounts of money for their retirement. But maybe not as much as we thought.

According to a new study by the University of British Columbia, rather than rolling over their 401(k) balances when they leave their jobs, a stunning 41.4 percent of U.S. workers choose to withdraw money instead. And the overwhelming majority of people who make a withdrawal—85 percent—withdraw the entire account.[1]

There are three significant reasons why, for most people, this is likely a terrible idea.

1. Taxable income. Remember that a traditional 401(k) is a tax-deferred account. It is not tax-free. You do not pay income tax when you contribute to the account. The employer generally withholds the contribution from your pay before the money can be subjected to income tax. The employer also often matches some of the contribution to the account, to incentive employees to save for retirement. There’s no tax going in, but when you take the money out it is considered ordinary income, and subject to income tax.

One further potential complication arises when you take the money out as you leave your job. If the amount is significant, not only is it all taxable, but it could also push you into a higher tax bracket for that year.

2. 10% penalty. There is also a 10 percent penalty if you withdraw the money before you reach age 59 ½. This is in addition to the federal and state income taxes you pay on this withdrawal.

There are a few exceptions to this early withdrawal penalty, though. Disability is one. You must meet the IRS definition of total and permanent disability as documented by your doctor. Death is another. You also won’t owe a penalty if the IRS draws on your account to collect unpaid federal taxes. Another exception—up to $5,000—is available for the adoption or birth of a child.

And finally, there is the “substantially equal payments” exception, also referred to as the 72(t) exception. This is when you take your distributions through a series of equal payments over time. There are many potential tax traps here, but the strategy would not be an option if you withdraw the entire 401(k) balance because you leave your job.

3. Erosion of retirement savings. As we’ve discussed previously, there is an ongoing retirement savings crisis in this country. Withdrawing money from a 401(k) before retirement doesn’t help. And two recent surveys indicate that last year’s record inflation has made the situation worse. According to TIAA, an international insurance company based in New York, 25 percent of U.S. workers have cut back on their retirement savings because of inflation. Even worse, 12 percent stopped saving entirely.[2]

Also, the Senior Citizens League, an advocacy group based in Alexandria, Virginia, surveyed over a thousand people aged 55 and older. They found that 49 percent of seniors spent at least some of their emergency savings in the first quarter of 2023, up from 38 percent in 2022.[3]

The 401(k) study generated some other interesting tidbits. For example, they concluded that a higher employer matching contribution rate actually increases what they refer to as the “leakage” rate, or the percentage of the account that comes out at job termination. The study estimates that a 50 percent increase in the employer match rate increases leakage probability by 6.3 percent at job termination. Or as they say, “Employers with more generous matches care about their employees’ well-being in retirement, but unintentionally nudge employees to cash out when they change jobs.”[4]

There are, of course, some good reasons why an individual would need to cash out of their 401(k), such as severe financial hardship. Remember to consult your tax advisor to help you fully understand the income tax implications of cashing out.  As a general rule, if you need money, this should be one of your last options.

[1] Wang, Yanwen, Zhai, Muxin, and Lynch, John G.  “Cashing Out Retirement Savings at Job Separation.”  Marketing Science, University of British Columbia, Vancouver V6T 1Z2, Canada (accessed May 4, 2023) https://pubsonline.informs.org/doi/full/10.1287/mksc.2022.1404

[2] Yakoboski, Paul Lusardi, Annamaria Hasler, Andrea. “Financial well-being and literacy in a high-inflation environment” TIAA Institute (accessed June 5, 2023), New York, NY.  https://www.tiaa.org/content/dam/tiaa/institute/pdf/insights-report/2023-04/tiaa_institute_gflec_2023_personal_finance_index_ti_yakoboski_april_2023.pdf

[3] Place, Nathan. “Record inflation has devastated America’s retirement savings.” Financial-planning.com. https://www.financial-planning.com/news/record-inflation-has-devastated-americas-retirement-savings?position=editorial_1&campaignname=V2_FP_BestoftheWeek_2021-05052023&bt_ee=5C0W0TOcz8ZTfdXSizcLEqX3Z2yxFKkgZXkuchG8Umt5fvvp%2FwzKIte9%2FHrXOZ4W&bt_ts=1683302581142(accessed May 3, 2023); Senior Citizens League, Alexandria, VA. “2023 Senior Survey” https://seniorsleague.org/2023seniorsurvey/ (accessed June 5, 2023)

[4] Wang, Yanwen, Zhai, Muxin, and Lynch, John G.  “Cashing Out Retirement Savings at Job Separation.”  Marketing Science, University of British Columbia, Vancouver V6T 1Z2, Canada (accessed May 4, 2023)  https://pubsonline.informs.org/doi/full/10.1287/mksc.2022.1404

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