Hands Off That 401(k) Cash

Question of the week:I'm 28 years old and have about $18,000 in my 401(k). I'm leaving my job for a new one next month and I'm thinking of cashing out my 401(k) to pay some bills and old college debts. What do you think? --Milwaukee Job Hopper Dear Job Hopper, You're certainly not alone in your temptation to use that money for something other than retirement. According to a study by global management consulting firm Hewitt Associates, 68 percent of 401(k) plan participants choose to take their money as a lump sum when changing jobs. But just because so many people do it certainly doesn't make it a good idea. I strongly urge you to think twice and carefully consider just exactly what the real cost of cashing out your 401(k) will be. Let's look at that $18,000. First, you'll have to pay a ten percent early withdrawal penalty to the IRS, along with regular income taxes on the money. Assuming that you pay 27 percent federal tax and five percent state tax, you'll wind up with just $10,440 after you pay the penalty and tax. Next, assume that you were to leave that $18,000 alone to continue its tax-deferred growth until you reach age 60-another 32 years. At an average annual return of 10 percent, it would grow to over $380,000. So cashing out that 401(k) really leaves you with just over half of what you had in your account and ultimately, $380,000 less for retirement. If the math alone doesn't convince you, take a look at some of the real-world experience of members of the Armchair Millionaire community who cashed out 401(k)s: "I cashed out and it was the worst financial mistake of my life. I used it to pay off credit cards, but it wasn't worth it. If I'd had a better understanding of the penalty and taxes that I ended up paying, I'd never have done it." --Suze G.T. "I had been laid off from my first real job and money was tight. I cashed it out, paid the tax and used the money for a down payment on my first home. Who knows what it would be worth now if I had only rolled it over …" --D. My checklist will give you the details on alternatives to cashing out that 401(k). The Armchair Millionaire's Checklist of 401(k) Choices for Job Changers Roll it over into a traditional IRA. This means simply moving your money from your 401(k) to an IRA. Any mutual fund company or brokerage will be able to supply you with information for setting up a rollover IRA and making the transfer. (By the way, be sure to do a direct rollover, where the money is sent directly from your 401(k) to your IRA. If you take the cash and then deposit it yourself into the IRA, you'll be subject to a 20 percent backup withholding tax.) Keep it with your old employer. As long as you have at least $5,000 in your account, you can leave it in your former employer's plan. You might opt to do this if you especially like the investment choices it offers or if you just need more time to decide what to do. If you have between $1,000 and $5,000 in the account, however, your employer may choose to roll it over to an IRA on your behalf. Roll it over to your new employer's 401(k) plan. Most plans allow you to do this. Your human resources department will be able to give you information on eligibility and the forms you need to arrange the rollover. THE BOTTOM LINE: If you're changing jobs and faced with the decision of what to do with the money in your 401(k), think carefully. It might be tempting to walk away with a handful of cash, but it will end up costing far more than you may think.