The essence of a retirement nest egg lies in the concept of patient growth and compounding investments over time. Its purpose is to provide a lush reserve of money when one retires from the workforce to ensure a comfortable retirement. However, a worrying trend is emerging as a significant portion of younger workers are succumbing to the temptation to deplete their nest egg prematurely.
The result is a tax bill, early withdrawal penalties, lost contributions, and a reduced—or vanished—account balance that likely won’t be enough when you retire. We’ll discuss the details.
A financial advisor can help you organize your retirement planning and ensure you meet your financial goals.
Employees cash in their 401(k) pension when they leave their job
More than 41% of workers who left their jobs prematurely terminated their employer-sponsored 401(k) retirement plans, according to a study by the UBC Sauder School of Business. That’s up from pre-pandemic levels, when about one in three departing workers withdrew cash or emptied their accounts entirely.
Such a move brings with it a number of financial problems. One of them is that the contributions are tax-free, while the withdrawals are treated as ordinary income and are subject to the employee’s marginal tax rate.
In addition, the IRS imposes a second deduction by imposing a 10% penalty on withdrawals before age 59½ (although there is an exception for employees age 55 and older).
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Other financial consequences
Employees can also lose a portion of the employer match of their 401(k) account if their account is not fully depleted, which can take up to four years. In addition, the employee misses out on valuable long-term interest earnings on all that untaxed money.
And employees who borrow against their 401(k) balances must repay the entire amount before the next federal tax return filing deadline. If employees don’t repay the amount by then, the remaining loan amount is treated as a distribution and as taxable income.
Payout depending on balance
There are also situations where employers may decide, depending on your account balance, to pay out your account when you terminate your employment:
Account balance under $1,000
The employer can write you a check, but it will not be for the full amount. The IRS requires the employer to withhold 20% to cover income taxes.
Loan balance between $1,000 and $5,000
The accounts can be involuntarily rolled over into an individual retirement account (IRA) in your name. At least that IRA is tax-free, so you won’t incur any tax charges. The bad news is that so-called “forced-investment” IRAs can come with high fees that can drain your account over several years.
Balance over $5,000
The employer cannot force you to leave the plan. You can simply leave the money where it is.
In all cases, it’s best to contact your Social Security office as soon as you know you’re leaving and get instructions for transferring your money to an IRA account at the institution of your choice. Any financial institution that offers IRAs can handle the transfer for you.
You may also be able to deposit your money directly into your new employer’s 401(k) plan, if allowed. Once you receive a check, you have 60 days to deposit that money into an IRA account, along with enough cash to cover the 20% withheld on the balance.
A financial advisor can help you understand the tax implications of your retirement accounts and how best to manage them. Contact a financial advisor today.
Bottom line
Workers who cash out their 401(k) balances when they leave their jobs face immediate taxes and penalties on the money. And it may not be enough to cover their long-term investments to meet their retirement needs.
Tips for preparing for retirement
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Retirement planning is complex and can be stressful. If you’re not sure what your vision is, consider talking to a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can survey your advisors for free to help you decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, get started now.
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Social Security is another source of income you can expect in old age. While you shouldn’t rely on it, it can help you cover minor expenses in retirement. Find out the amount you’ll receive with our free Social Security calculator.
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Have an emergency fund ready in case unexpected expenses arise. An emergency fund should be liquid – in an account that is not exposed to the risk of large fluctuations like the stock market. The downside is that the value of liquid cash can be eroded by inflation. However, a high-yield account allows you to earn compound interest. Compare savings accounts from these banks.
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The post “Alarming number of working Americans are liquidating their retirement accounts when they change jobs” first appeared on the SmartAsset blog.