Cashing out a 401(k) -- Why?
Interesting stat, spotted in Kiplinger's: 45% of 401(k) participants cash out the balance when they leave their job. There is no explanation why so many people make this unwise decision, but I have a few suspicions:
1) There's not much money in the 401(k) account. For younger workers, a 401(k) with just a few thousand dollars doesn't seem worth rolling over, especially in light of college loans, living expenses, and retirement four decades away. In the case of older workers, such a small amount may not seem worth rolling over, as it won't have as much time to appreciate in value, and other necessary expenses are more compelling (see next point)
2) People need the money. The money might be needed for an emergency, or necessary expenses -- legal fees, college costs, debt repayments, healthcare, car repairs.
3) People don't understand how a rollover works, or the tax hit from cashing out. Lots of people are turned off by financial paperwork. That's no excuse, but it's just a recognition that the processes involved are hard for some to understand, and/or too much of a hassle for others. The tax repurcussions of cashing out may also be underappreciated -- until April rolls around, and they find that they owe money to Uncle Sam for withdrawing money that has sheltered from income tax.
4) People are greedy. I hate to say it, but there are lots of people out there who live according to short-term materialistic whims, and see a 401(k) account from their last job as a pot of money that can be used on a flat-screen TV, new car, or shopping spree.
5) The new job's benefits seem to counterbalance cashing out an old job's 401(k). You've just been hired by a new firm, which comes with a better title and a higher salary. Therefore, cashing out the old job's 401(k) might not seem like such a big deal.
6) Why bother? There's an additional reason that I heard from a friend: he cashed out his 403(b) (like a 401(k), but for employees in the the public sector jobs and nonprofits) because his parents are rich, and he anticipates inheriting a lot of money.
Except for certain scenarios outlined in point no. 2, none of these reasons seem compelling enough to me to justify cashing out. But still, millions of people do it every year. You can't force them to be more responsible, only hope to educate them about the benefits of investing as much as they can in their 401(k)s and IRAs. Social Security isn't enough to retire on!
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When I left my last job, I chose to cash out my 401k. There was only a few thousand dollars in it, and it wasn't a huge portion of my holdings. I chose to cash out instead of a direct rollover and I used the money to purchase a home (my plan adminstrator did not allow loans on inactive employees, and I did not have the option of rolling into my new 401k).
After doing all my calculations, the tax hit and the early withdrawal penalties on such a small amount were neglible compared to the tax breaks I get as a homeowner. Sure I could've chosen to roll the money over and keep it in a retirement account, but that would have led me to spending money on rent for another year (I *needed* the money from the cash-out in order to buy a house).
Cashing out my 401k led me to a much better place financially. Though I wholly admit that my situation is an edge case, and it is usually not a smart move to cash out a 401k (especially if there's a high balance), and I must note that it is no harder to rollover than it is to cash out.
Thanks for your story, Cory. Your situation falls under the first and second points I listed above -- using the money to help make a down payment on a house. It's not a life-or-death situation, but becoming a homeowner is a necessity for many people, and, as the old saying goes, can be the best investment you can ever make. That's a good point about how the tax deduction on mortgage payments over many years will outweigh the additional tax hit from cashing out your 401(k) -- and will also stop the outflow of money to pay the rent.
