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Avoid a "Cashing In" Debacle
By Stephen J. Butler Archives

A reader writes that he has just changed jobs and is considering cashing in his 401(k) funds of $5,000. He wants to pay off an equal amount of student loans and credit card debt.

I'm guessing that his desire to pay off debts has more to do with psychology than money management. He doesn't want those college loans hanging over his head. Plus, they remind him too much of exams and term papers.

Answer: Put the $5,000 into a new IRA rollover account with BUYandHOLD. Do not cash in! Taxes and penalties on an early 401(k) distribution will be almost 45%, because this money will be taxed at your highest tax rate.

Remember, the money you are withdrawing will be over and above your regular job income. In states with high state income taxes, for a single taxpayer, the combined state and Federal tax rate on every dollar of earnings beyond $27,337 is taxed at approximately 36 percent. In addition to these taxes, you will pay an early-withdrawal penalty of 10% to Uncle Sam and 2% to most states. You will lose an astounding 48% of your $5,000, leaving you with only $2,600. Ouch!

To avoid this disaster, keep your money warm, dry and happy in the tax-sheltered environment of a rollover IRA. If you want to keep things simple, design your IRA portfolio around some diversified companies that reflect the overall stock market. Long term market returns have been about 10% per year. Money at this rate doubles about every 7.2 years. Compare that to the onerous losses you'd suffer by withdrawing the cash.

As a general rule, NEVER take money out of a retirement plan to pay debts. Instead, use the pressure of debts to stimulate more responsible spending.

One of the most disappointing statistics about 401(k) plans is the extent to which people cash in their plan accounts and spend the money when they change jobs. In most cases, the plan money is a relatively small amount -usually less than $5,000. The reasoning seems to be that a modest sum is of little consequence retirement-wise, so why not blow it now on a purchase or vacation, even if almost half of the money is lost to taxes and penalties.

This kind of thinking is a huge mistake. It's especially grievous for younger people who could easily accumulate one million dollars over forty years from just that single $5,000 account balance - if they left that money in the plan for decades of bountiful compounding.

Cashing in early from your 401(k) is a seriously bad idea. It's painful to see so many people inflict such damage on their personal assets. In my e-mail response to my reader, I concluded by saying, "If you cash in your 401(k), don't tell me about it. It would leave me too depressed to write this column for a couple of weeks."

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results.

Steve Butler is president of Pension Dynamics Corp. in Lafayette and author of the new book, "401(k) Today." Send your questions for Steve to MR401K@pensiondynamics.com

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.