Personal Finance: Warning lights flash on early 401k cash outs

Personal Finance: Warning lights flash on early 401k cash outs

May 14th, 2014 by Chris Hopkins in Business Diary

Chris Hopkins

Chris Hopkins

Photo by Patrick Smith /Times Free Press.

In the decade leading up to the financial crisis, home equity loans became the first place to go when households felt a financial pinch. With the mortgage meltdown and declining home values, this avenue is now closed to many cash-strapped families. Today, a trend with more insidious implications for the future has gained momentum: early withdrawals from company retirement plans.

This trend has been especially prevalent among job-changers who elect to cash in their chips rather than bother to roll over into their new employer's plan. But the number of workers seeking early withdrawals from their current company has also increased significantly. These developments have disturbing implications for a population that is already drastically under-saving for retirement.

Retirement accounts like 401k plans, 403b plans, and IRA accounts are tax-advantaged vehicles created to assist workers in saving up for retirement in an era in which traditional pensions are as rare as the dodo bird. To encourage a long-term investment horizon, the tax code stipulates penalties for withdrawal of contributions before reaching age 59 1/2. Increasingly, participants are taking the money and paying the penalty to their detriment over the long run.

According to data from the IRS, taxpayers coughed up $5.7 billion in early distribution penalties in 2011. That implies that a total of $57 billion was withdrawn early from retirement accounts and is no longer available to cover future expenses in retirement. And information from the Federal Reserve for 2010 indicates that nearly one in 10 people with a retirement account were penalized during that year.

Interestingly, some of the people most adversely affected by premature distributions are younger workers, thanks to the phenomenal power of compounding. A study conducted by Fidelity Investments found that over one-third of all 401k plan participants have cashed out, usually upon changing jobs. Workers aged 20 to 39 bailed out at the highest rate, and averaged $14,000 in early distributions subject to the 10 percent penalty as well as taxation at their highest tax bracket. That's a killer.

To illustrate the damage, consider a 30-year-old worker with the average $14,000 balance. Including the penalty and assuming a 25 percent tax rate, this youngster would keep just $9,100 upon opting for early withdrawal (ignoring any state taxes). Had he rolled it in instead into an IRA with an average 7 percent annual growth rate, he would have amassed $75,000 by age 65, enough to provide a monthly income of over $500 in retirement. Not exactly chump change.

With the demise of the traditional defined benefit pension, it is especially crucial to maintain the sanctity of the tax deferral and compounding power of defined contribution plans. Even small balances accrued by younger workers can grow into substantial nest eggs over 20 or 30 years, if left untouched.

Obviously exigencies arise, and sometimes pressing expenses require drastic actions. But if at all possible, consider taking a loan from your 401k plan before initiating an early withdrawal. And if you change jobs, don't assume that a small balance is not worth the trouble to roll over. Whether or not Einstein actually said it, compound interest remains one of the most powerful forces in nature.

Christopher A. Hopkins, CFA, is vice president at Barnett & Co. Advisors.