Despite years of reasoning, wheedling and sermonizing from financial advisers and retirement planners, nearly half of all workers who change jobs cash out their 401(k) plan savings instead of leaving them to grow, either there or in some other form of tax-deferred account, according to a new study.
This behavior, at best, deprives workers of years of compounding, which can do miracles for even modest sums. At worst, it could undermine the entire premise of these "defined contribution" retirement plans, which is that a combination of worker prudence, employer assistance and tax benefits will enable workers to build up adequate nest eggs for their retirement years.
And there are additional costs. Cash withdrawn from a 401(k) is subject to ordinary income taxes, and for workers under age 59 1/2, there is a 10 percent tax penalty as well.
Cashing out has long been most common among workers with small balances, and it remains so, the survey found. Some 87 percent of workers with accounts of less than $5,000 opted to take cash, as did nearly three-quarters of those with balances between $5,000 and $10,000. But even as balances approached $50,000 the survey found one in five workers taking the cash, and even among accounts of $80,000 to $89,000 some 10 percent of job changers cashed out.
The majority of those who did not cash out rolled their balances over into individual retirement accounts. Others left the money with their previous employer or transferred it to their new employer’s plan. All of those moves avoid taxes and penalties and allow the money to continue growing tax-deferred.
The study did not look at what workers did with cash when they took it, but Stacy Schaus, a consultant with Hewitt Associates, the benefits consulting firm that did the study, said anecdotal evidence suggests most of it went for such things as living expenses and credit card debt.
Cash-outs were most common among younger workers, who, of course, are most likely to have small balances. But these younger workers are precisely the ones who can benefit from decades of compounding. In cashing out early, these younger workers lose an important chunk of the long-term potential of their 401(k)s. Hewitt calculated that a 25-year-old who cashes out a $5,000 balance potentially gives up about $75,000 — which is what the $5,000 would grow into by age 65, assuming a 7 percent annual return. If that same worker then changes jobs at 30 and 35, and again cashes out his balance, the potential loss at retirement balloons to $165,000 at a 7 percent return, and to $230,000 if his investments averages 8 percent.
These unhappy findings are not likely to deter employers from shifting to these plans. The number of companies offering traditional pensions, which promise a lifetime stream of income to workers in retirement, has declined drastically over the past 20 years, partly because employers have found funding those pensions a burden.
But the Hewitt study and others like it raise serious public policy questions. The Bush administration apparently has not given up on the idea of allowing almost everyone to fund large IRA-like accounts, notwithstanding the evidence that many workers have difficulty funding even small accounts. Such a proposal, while appealing to people with the wherewithal to save, could magnify a looming split in the retiree population between those with enough to live on and those without.
And savers shouldn’t feel smug. If the number of people without adequate retirement resources gets large enough, those folks will likely play "what’s mine’s mine and what’s yours is ours" at the ballot box.
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